CFTC Chair Gensler Asks Congress for Changes to Administration's Draft Legislation Regulating Derivatives

In a letter to Congress, CFTC Chair Gary Gensler has asked for specific changes in the Obama Administration’s draft legislation to regulate the OTC derivatives markets. While praising the legislation as an important step toward comprehensive regulation of both derivatives dealers and derivatives markets, the CFTC Chair said that the legislation must cover the entire marketplace without exception and also remain true to its vision of parallel SEC-CFTC swap regulatory regimes.

Thus, he urged the Administration to drop the exclusion for foreign exchange swaps currently contained in the draft. He fears that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign exchange exclusions and thereby avoid regulation. He also asked that dual SEC-CFTC regulation of mixed swaps be deleted. The letter was sent to Senate Ag Committee Chair Tom Harkin (D-IA) and Ranking Member Saxby Chambliss (R-GA). The letter was copied to Senate Banking Committee Chair Chris Dodd (D-CT) and Ranking Member Richard Shelby, as well as to House Ag Committee Chair Collin Peterson (D-MN) and Financial Services Chair Barney Frank (D-MA)

Chairman Gensler fears that currency and interest rate swaps could be broken down into their component parts and then restructured to resemble a series of foreign exchange forwards or a foreign exchange swap to come within the scope of the proposed foreign exchange exclusions. There is also a risk that these exclusions may have the unintended consequence of undermining the CFTC’s enforcement authority over retail foreign currency fraud enacted by Congress as part of last year’s Farm Bill.

Moreover, Mr. Gensler said that the proposed exception from the mandatory clearing and exchange trading of standardized swaps when one of the counterparties is not a swap dealer or major swap participant excludes a significant class of end users and may undermine the policy objective of lowering risk through bringing all standardized OTC derivatives into centralized clearing. It may also undermine the policy objective of increasing transparency and market efficiency through bringing standardized OTC derivatives onto exchanges.

While the proposed legislation includes important protections with respect to insolvency risk involving OTC swaps, Mr. Gensler asked Congress to include several additional measures to protect customers and counterparties in the event of a bankruptcy of a swap dealer. Specifically, the legislation should impose a mandatory set-aside requirement with respect to collateral received by swap dealers. As envisioned by the Chair, this set-aside requirement would be equivalent to the CEA’s segregation requirement for futures, which has effectively protected customer funds from loss ever since the CFTC was created in 1974.

As important, the legislation should amend the Bankruptcy Code to afford, in the event of a swap dealer bankruptcy, swap counterparties and customers of swap dealers similar protections as those currently available to futures customers of commodity brokers, including the transfer of customer funds to other solvent commodity brokers in the event of a bankruptcy without violating the automatic stay or being subject to the bankruptcy trustee’s avoidance powers.

Mr. Gensler also asked Congress to strike out the mixed swap provisions of the proposed draft, which provide for the dual SEC-CFTC regulation of swaps that derive their value from both a security and a commodity. The mixed swap provisions are a departure from the legislation’s vision of allowing the CFTC and SEC to separately administer parallel regulatory regimes with respect to swaps and security-based swaps. Mr. Gensler suggested that the legislation should subject such swaps to SEC regulation if their value is based primarily on a security or narrow-based security index, or to CFTC regulation if their value is based primarily on something else.