Wednesday, April 13, 2011

Senate Hearings on Implementation of Dodd-Frank Derivatives Title Focus on End Users and Global Consistency of Regulations

Senate Banking Committee hearings on the SEC and CFTC’s implementation of the derivative provisions of Dodd-Frank focused on the end user exemption, regulatory arbitrage and the upcoming Treasury decision whether to exempt foreign exchange swaps. Committee Chairman Tim Johnson (D-SD) asked how the SEC and CFTC are coordinating the adoption of regulations implementing the derivatives provisions of Dodd-Frank. SEC Chair Mary Schapiro said that the SEC and CFTC are very focused on joint rulemaking. Although the security-based swap and swap markets are very similar, she noted, the differences in the regulations, such as they might be, are driven by the fact that some products may trade differently.

She said that the SEC and CFTC have worked closely together through the proposal stage and will continue to do so as the rules are finalized. After implementation, the SEC may have occasion to issue interpretations of the regulations to make them more consistent. Agreeing with Chairman Schapiro, CFTC Chair Gary Gensler said that differences in SEC and CFTC derivatives regulations are sometimes driven by statute and sometimes by market practices. Chairman Gensler said that the Commissions will adopt regulations in a way that avoids intra-Commission regulatory arbitrage.

Importantly, Chairman Schapiro noted that the SEC is working with the CFTC to adopt joint rules further defining key terms relating to the products covered by Title VII and certain categories of market intermediaries and participants. In her view, joint rulemaking regarding key definitions will promote regulatory consistency and comparability, and thus help to prevent regulatory gaps that could foster regulatory arbitrage.

Chairman Johnson is also concerned about harmonizing the SEC and CFTC derivatives regulations globally. Mary Miller, Assistant Treasury Secretary for Financial Markets, said that the cross-border harmonization of derivatives regulations is very important. Treasury is conducting a dialogue on harmonization with international derivatives regulators, as well as with the Financial Stability Board, which the G-20 has charged with the overall monitoring of financial regulation to ensure global consistency.

The SEC Chair noted that the Commission is fully cognizant that other jurisdictions are also developing derivatives regulatory frameworks. The manner and extent to which the SEC and CFTC and foreign regulators regulate derivatives will affect both U.S. and foreign entities and markets. Consequently, she pledged that as the implementation of Title VII progresses, the SEC will continue to consult with regulatory counterparts abroad in an effort to promote consistent standards and avoid conflicting requirements, where possible.

The SEC and CFTC are, in fact, directed by Dodd-Frank coordinate with foreign regulators on the establishment of consistent international standards governing swaps, security-based swaps, swap entities, and security-based swap entities. Bilateral discussions with foreign regulators, as well as engagement in the IOSCO Task Force on OTC Derivatives Regulation, which the SEC co-chairs, will help the Commission achieve this goal.

Federal Reserve Board Governor Daniel Tarullo said that international coordination on derivatives regulation has been very good, especially in the areas of central counterparties, electronic trading, and risk management. More work is needed on margins for non-cleared swaps, he noted, but he is confident a consistent international position can be achieved in this area as well. Governor Tarullo also mentioned as a positive development the joint rrecommendations of the IOSCO Technical Committee, chaired by SEC Commissioner Kathleen Casey and the Committee on Payment and Settlement Systems, chaired by NY Fed President William Dudley, for central counterparties and clearing arrangements for OTC derivatives.

Committee Ranking Member Richard Shelby (R-AL) expressed concern with the status of an end user exemption for non-financial companies and the impact of Dodd-Frank Title VII on job creation. Treasury official Mary Miller assured the Senator that Dodd-Frank provides sufficient flexibility for regulators to create an end user exemption for companies to manage risk. She added that Treasury has not done any specific work on Dodd-Frank’s impact on job creation.

Senator Shelby inquired about how close Treasury was to making a decision on whether to exempt foreign exchange swaps. Dodd-Frank authorized Treasury to determine whether foreign exchange swaps should be exempted from the definition of swap in the Commodity Exchange Act. Ms. Miller replied that Treasury is very close to making a decision in that area. She added that many parts of the foreign exchange market were under severe stress and some parts will probably be subject to Dodd-Frank regulation.

The Ranking Member also asked assurances that there will be no taxpayer bailouts of derivatives clearing houses. Fed Governor Tarullo said that systemically important clearing houses will be regulated by their primary regulator, and he feels that there will be convergence among the primary regulators, and the Fed will engage in prudential supervision, drawing on its experience, and will look to safety and soundness as well as market structure.

Citing a letter from the UK FSA Director of Markets to the CFTC, Senator Shelby asked about the regulation of central clearing houses. In the letter, the FSA urged the adoption of transparent and non-discriminatory rules, based on objective criteria, governing access to central counterparties. Chairman Gensler said that central clearing houses need robust oversight. In this regard, he views the CFTC as being in partnership with the Fed, with the CFTC as primary regulator. Clearing houses have not failed in this country, he said, but they need proper default management.

With regard to the FSA comment letter, Chairman Gensler said that there must be open membership, it can not be narrow. The CFTC Chair agrees with Senator Shelby that, given the international aspect of derivatives, it is imperative to listen to the views of the FSA and other international regulatory counterparts. Chairman Gensler agreed with Senator Shelby that it would be dangerous to create an exclusive club for clearing houses, noting that Dodd-Frank commands that it must be more open.

Senator Robert Corker (R-TN) noted the concerns of market participants over the rapidity of the derivatives rulemaking and the prescriptive nature of the proposed rules, specifically mentioning that the CFTC proposal on swap execution facilities would require that requests for quotes be sent to at least five dealers. Chairman Gensler noted that the proposal responds to Dodd-Frank’s desire for transparency and multiple participants, adding that the five-quote rule would apply to non-block trades, with large block trades excluded.

Senator Corker was also concerned about high frequency trading when swaps move to platforms. Chairman Gensler said that issue is very much on the CFTC’s mind

Senator Pat Toomey (R-PA) is concerned that the proposed rules on position limits are not being coordinated with international regulatory counterparts. Chairman Gensler assured the Senator that the CFTC is working with its global counterparts to assure harmonized rules on position limits.

Senator Jerry Moran (R-KN) asked if we will see the entire mosaic of the derivatives regulatory picture before the rules are finalized. Chairman Gensler said that the mosaic will be revealed and mentioned in that regard meetings in May with the SEC.