In the wake of the JP Morgan trading loss and the ongoing efforts to complete regulations implementing the Dodd-Frank derivatives and Volcker regulations, and their international harmonization, the Senate Banking Committee questioned the Chairs of the SEC and CFTC. Committee Chairman Tim Johnson (D-SD) called for full congressional funding for federal financial regulators in light of the JP Morgan trading loss. He also noted that higher margin for uncleared swaps and real time reporting requirements mandated by the Dodd-Frank Act will improve the transparency and regulation of swap trading between large financial firms. He commended the SEC and CFTC for their tireless efforts in implementing the Dodd-Frank reforms and urged the Commissions to take a unified approach to swaps regulation, minimizing differences in order to improve compliance and decrease the cost of compliance. In addition, Chairman Johnson said that harmonizing the regulations domestically will assist in the international harmonization of derivatives regulations.
Senator Mike Johanns (R-NE) emphasized that the international harmonization of the derivatives and Volcker regulations could be a serious problem as different jurisdictions could have different agendas and economic interests. Senator Mark Warner (D-VA) is also concerned about the international implications of the derivatives regulations, and the extraterratorial application of US laws and regulations, such as when you have derivatives transactions involving a foreign subsidiary of a large
CFTC Chair Gary Gensler noted that, while the agencies are making real progress on the global harmonization of derivatives regulation, there will be differences. US regulators will have to somewhat rely on substituted foreign compliance regimes. He said that the CFTC is advocating globally that end users should not be required to post margin.
SEC Chair Mary Schapiro said that the SEC will soon lay out a comprehensive approach to the cross-border application of derivatives regulation that will inform each and every rule. She noted that foreign regulators have a deep interest in the finalized
Rather than deal with the international implications of Title VII derivatives regulation piecemeal, she explained, the SEC will address the relevant issues holistically in a single proposal. The publication of such a proposal is intended to give investors, market participants, and foreign regulators an opportunity to consider as an integrated whole the SEC’s proposed approach to the registration and regulation of foreign entities engaged in cross-border transactions involving
parties. Thus, this release
will be published prior to the finalization of the rules discussed therein so
that the comments received can be taken into account in drafting the final
The application of Title VII to cross-border transactions raises a substantial number of complex issues, said Chairman Schapiro, including consideration of foreign regulatory frameworks and competition concerns. While acknowledging that this is not an easy task, Chairman Schapiro believes that the publication of a fully developed, comprehensive SEC proposal to address these issues, and the opportunity for all interested parties to comment on the proposal, will significantly advance the level of understanding, and greatly facilitate public dialogue, on these issues
Committee Ranking Member Richard Shelby (R-AL) said that there is still widespread uncertainty about the regulation of derivatives, adding that the SEC and CFTC still have not proposed regulations clarifying the definition of a swap. If market participants do not know which activities will fall under swap activities, he reasoned, how can they know what falls under trading and clearing rules.
SEC Chair Schapiro stated that the Commission is developing a policy statement regarding how the substantive requirements under Title VII derivatives regulation within its jurisdiction will be put into effect. This policy statement would be designed to establish an appropriate and workable sequence and timeline for the implementation of these rules. As a purely practical matter, she noted, some of these rules will need to go into effect before others can be implemented, and market participants will need a reasonable, but not excessive, period of time in which to comply with the new rules applicable to security-based swaps. The policy statement should give market participants a degree of clarity as to how the Commission, in general, is thinking of ordering the compliance dates of the various sets of rules under Title VII. The SEC intends to publish the policy statement for public comment in the very near term, said Chairman Schapiro.
JP Morgan Trading Loss
In response to questions on the Commissions and the JP Morgan trading loss from Chairman Johnson and Ranking Member Shelby, CFTC Chair Gensler noted that credit default swaps indices apparently traded by JP Morgan come under the CFTC’s antifraud and anti-manipulation regime. The bank was not regulated as a swap dealer because those regulations are not yet in place.
SEC Chair Mary Schapiro said that the JP Morgan trading in question took place in a London-based bank and not in the broker-dealer supervised by the SEC. The SEC had no direct oversight of the trades since none of the transactions were executed in the
Senator Robert Corker (R-TN) noted that an event like the JP Morgan trading loss during a rulemaking process affects the regulations that are being created. Chairman Gensler noted that the event provides a real-life lesson in the need for transparency and lower risk, which is a twin goal of the regulations. It also shows again that the cross-border application of the regulations is important since this was a London-based risk.
Senator Corker also feared that the JP Morgan trading loss may cause complex financial institution to not appropriately hedge risk. Senator Jeff Merkley (R-OR) said that the Volcker Rule creates a firewall between traditional banking and hedge fund-like activities. He noted that the draft regulations have a liquidity management proposal. Chairman Schapiro said that the rationale of the liquidity management exclusion is to allow banks to satisfy their short-term liquidity needs. The liquidity management plan must be documented.
The SEC Chair said that regulators should go back and look at the proposed liquidity management exclusion to see if it should be tightened.
Senator Merkley who, along with Senator Carl Levin (D-MI), is a co-author of the Dodd-Frank Volcker Rule provisions, said that financial institutions can hedge to address specific risk so long as the hedging does not give rise to additional risk exposure.
Chairman Schapiro noted that there is a continuum from a plain vanilla hedge to a point where the transaction is no longer a hedge. She noted that the proposed Volcker regulations have lots of metrics to help ascertain how behavior changes over time in a firm, and how transactions change over time.
To Senator Merkley’s query if it is a red flag when there is insurance on a larger quantity of risk than a firm actually holds, Chairman Schapiro said that there might well be because in that situation the hedge might be giving rise to significant exposure because the firm has over-hedged the position. The hedge should be risk reducing.
Senator Merkley referred to a colloquy he engaged in with Senator Levin which said that you must identify the specific risks that you are hedging.
Dodd-Frank provides an exemption from the prohibition on proprietary trading for risk-mitigating hedging activities in connection with and related to individual or aggregated positions that are designed to reduce the specific risks in connection with such positions. The proposed regulations require that the hedging transaction be reasonably correlated to the risks that the transaction is intended to hedge.
Chairman Gensler noted that it is a challenging task to ban proprietary trading and allow hedging and market making. He agreed that the hedge must lower risk. Regulations must say that hedging a specific risk is permitted if it is reasonably correlated. But he cautioned that a hedge can mutate when you have a separate trading desk motivated to ``swing for the fences.’’
Senator Merkley noted that the phrase reasonably correlated is important because correlated by itself would suggest something could be barely correlated and meet the test. He urged the regulators to define reasonably in this context, noting that it is meant to identify the specific risk.
The SEC believes that business must be able to engage in market making and hedging to reduce risk. But regulators must keep the focus on hedging that is truly hedging. The hedge must not give rise to significant exposures, noted the SEC Chair, and compensation programs cannot incentivize risk taking. The regulators must write regulations allowing legitimate risk mitigating hedging to go forward. Chairman Gensler said that, while portfolio hedging can mean different things to different people, it has to be tied to specific risk positions.
FSOC and Title I and II of Dodd-Frank
Senator Warner noted that Title I of Dodd-Frank created the Financial Stability Oversight Council as a resolution forum. As part of that, Congress also created the Office of Financial Research as an independent repository of data in order to give the FSOC the ability to adjudicate any conflicts among and between the SEC, CFTC, the Fed and the other federal financial regulators as they adopt regulations implementing the Volcker Rule and derivatives provisions of Dodd-Frank. Senator Warner, a key player in the enactment of Titles I and II of Dodd-Frank, views the FSOC mainly as an adjudicating body.
Chairman Schapiro said that the FSOC is a very good forum for regulatory agencies to share concerns and ideas and differences and to get unique views on different but connected regulations. Among other things, the FSOC has helped to foster strong bi-lateral relationships among regulators. She noted that FSOC is currently working on its next annual report, which will lay out systemic risk issues. The SEC Chair also noted that the OFR is starting to get going in a meaningful way and can be an important adjunct for the regulatory agencies. It is working well, averred the SEC Chair.
Chairman Gensler said that FSOC is an enhancement over the President’s Working Group on the Financial Markets, which it replaced. While FSOC is more formal than the PWG, he observed, and has not yet been tested in a real crisis, the CFTC Chair believes that it will serve better than the PWG.
On the question of liquidating a failed financial firm under Title II, Senator Warner said that it is important to understand how Title II liquidation relates to derivatives. He explained that Title II ensures that any firm going into its liquidation regime is actually liquidated and that there is no taxpayer support. While the SEC and CFTC are not primarily involved in that liquidation process, he noted, the proper handling of swaps will be very important.
Chairman Gensler noted that the central clearing of swaps will help a lot in the Title II context. The most challenging piece will be the swaps that are not cleared, since they leave a tangled web of interconnecedness. In this regard, he said that it is important to get the margin rules right. He said that the CFTC is working with the FDIC and Fed on this and other Title II issues. He also mentioned that the stay provision in Title II may impact on uncleared swaps in a challenging way.
Senator Shelby said that, while you cannot take risk out of the marketplace, he does not know of a well capitalized, well managed and well regulated firm that has gotten into trouble. The Senator also called for transparency, adding that regulated financial firms should not operate in the dark.
Senator Warner cautioned that capital standards that are too stringent could make financial institutions non-competitive. Thus, the regulators must engage in a balancing act.