Hedge Fund Industry Supports House Draft Legislation Regulating OTC Derivatives Markets

The hedge fund industry has expressed qualified support for the House Financial Services Committee draft legislation regulating the OTC derivatives markets. In testimony before the committee, the Managed Funds Association expressed full support for the broad goals of the Over-the-Counter Derivatives Markets Act of 2009 to reduce systemic risk through the use of central clearing houses, the segregation of customer collateral by central clearing houses, and by providing customers with the option of having their collateral for customized swaps segregated. The MFA also endorsed provisions increasing transparency through trade and position reporting and providing the government with additional authority to avert and respond to economic or financial turmoil without disrupting ordinary market operations. The draft is being circulated by Barney Frank, the committee Chair. It is expected to be marked up in October.

The MFA favors the registration and regulation of swap dealers along the lines provided by the draft, with oversight of swap dealers consistent with the oversight of securities dealers. Also, registration and regulation, such as trade and position reporting, will largely close the regulatory gaps that currently exist in the OTC derivative markets since most swaps transactions are effected with a swap dealer. In particular, the reporting requirements imposed on swap dealers will help assure that all material information is available to the SEC and CFTC.

Calling the term “substantial net position” overly broad and subjective, the trade group urged Congress to direct the SEC and CFTC to publish objective standards for purposes of defining a “substantial net position” in order to provide market participants with a clear understanding of the regulatory boundaries for becoming a major swap participant. The SEC and CFTC should be directed to consider the relative net position of swap dealers, the participant’s average net position over a relative period of time, such as a year, whether the participant’s counterparties have a substantial unsecured credit exposure to such participant from outstanding swaps, whether the participant holds assets belonging to retail customers; and whether the participant is an existing registrant with either the CFTC or SEC.

The draft authorizes the SEC and CFTC to ban abusive swaps. The MFA fears that the authorization is overly broad and vague, and lacks clear statutory and public policy goals. The use of a swap to manipulate the market is more appropriately addressed through the current antifraud and anti-manipulation authority of the SEC and CFTC.

The MFA has strong concerns with draft provisions authorizing the SEC and CFTC to impose position limits in the swap markets. The statutory purpose or public policy objective behind position limits is unclear, said the MFA, and the draft does not provide the SEC and CFTC with adequate guidance as to the policy objectives behind position limits. Position limits do not address systemic risk concerns, noted the MFA, which can be addressed through capital and margin charges. More generally, the MFA believes that position limits should only be imposed for physically-delivered commodities and only where the deliverable supply of the commodity is limited and, thus, subject to control and manipulation.

The MFA supports the draft provision requiring swap dealers to offer customers the availability of collateral segregation. The group believes that the benefit that the financial system will derive from the mandatory clearing of standardized products will be substantially multiplied if consistent protections are at least made available with respect to non-cleared products.

According to the MFA, the draft does not go far enough in promoting the use of clearing organizations to clear standardized OTC derivative products. The draft would only make central clearing mandatory after the SEC or CFTC determines clearing is appropriate for a particular swap, and even then only as to swaps involving a limited group of participants. The MFA urged Congress to make the OTC derivatives regulatory framework available to end-users engaging in standardized trades by allowing end-users that post cash collateral to have access to central clearing either through direct participation in a clearing organization or through a swap dealer.

With regard to clearing organizations, the MFA supports draft provisions mandating that governance arrangements be transparent and taking into account the views of all market participants. It is also proper to mandate that membership standards are fair and open, including with respect to access by non-dealers.

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