We all now know that the decision to leave the credit default swaps market largely unregulated didn’t really work out too well. The Commodity Futures Modernisation Act of 2000 has even been criticised by those who helped create it.
Lax regulation + excessive risk taking + generally poor risk management + complex instruments that few really understood = not a good idea.
So why has there been so little debate over the Obama administration’s proposals, announced on Tuesday, to comprehensively regulate CDS along with the rest of the OTC world?
Most of the proposed legislation is relatively uncontroversial. It provides for regulation and transparency for all OTC derivative transactions, dealers and other major participants. But the plan also calls for a big chunk of the regulatory work to be shared – between the SEC and the CFTC.
Are regulators, anywhere in the world, good at sharing anything?
Key details of the proposals include:
1. Regulation of OTC Derivative Markets
Require Central Clearing and Trading of Standardized OTC Derivatives:
- To reduce risks to financial stability that arise from the web of bilateral connections among major financial institutions, the legislation will require standardized OTC derivatives to be centrally cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC.
- To improve transparency and price discovery, standardized OTC derivatives will be required to be traded on a CFTC- or SEC-regulated exchange or a CFTC- or SEC-regulated alternative swap execution facility.
Move More OTC Derivatives into Central Clearing and Exchange Trading:
- Through higher capital requirements and higher margin requirements for non-standardized derivatives, the legislation will encourage substantially greater use of standardized derivatives and thereby will facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges.
- The legislation proposes a broad definition of a standardized OTC derivative that will be capable of evolving with the markets.
o An OTC derivative that is accepted for clearing by any regulated central clearinghouse will be presumed to be standardized.
o The CFTC and SEC will be given clear authority to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.
Require Transparency for All OTC Derivative Markets:
- Accordingly, all relevant federal financial regulatory agencies will have access on a confidential basis to the OTC derivative transactions and related open positions of individual market participants.
- In addition, the public will have access to aggregated data on open positions and trading volumes.
2. Regulation of All OTC Derivative Dealers and Other Major Market Participants
Extend the Scope of Regulation to Cover all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets:
- Our legislation will require, for the first time, the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives.
Bring Robust and Comprehensive Prudential Regulation to all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets:
- Under the legislation, OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies. OTC derivative dealers and major market participants that are not banks will be regulated by the CFTC or SEC.
- The federal banking agencies, CFTC, and SEC will be required to provide robust and comprehensive prudential supervision and regulation – including strict capital and margin requirements – for all OTC derivative dealers and major market participants.
- The CFTC and SEC will be required to issue and enforce strong business conduct, reporting, and recordkeeping (including audit trail) rules for all OTC derivative dealers and major market participants.
3. Preventing Market Manipulation, Fraud, and other Market Abuses
Provide the CFTC and SEC with the Tools and Information Necessary to Prevent Manipulation, Fraud, and Abuse:
- The legislation gives the CFTC and SEC clear, unimpeded authority to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivative markets.
- The CFTC and SEC will be given the authority to set position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets.
-The full regulatory transparency that the legislation will bring to the OTC derivative markets will assist regulators in detecting and deterring manipulation, fraud, insider trading, and other abuses.4. Protecting Unsophisticated Investors
Better Protect Unsophisticated Investors from Abuse in the OTC Derivative Markets:
- The legislation will tighten the definition of eligible investors that are able to engage in OTC derivative transactions to better protect individuals and small municipalities.
Given this shared approach to regulatory jurisdiction, the cultural differences between SEC and CFTC s could be a real problem. The CFTC has traditionally been geared towards ensuring the integrity of markets. It tends to use a ‘principles-based’ approach to regulating futures. The SEC, however, is more focused on protecting individual investors. It regulates securities with more prescriptive regulations.
Some will argue that the administration has anticipated these issues with the appointments of Mary Schapiro and Gary Gensler to head up the SEC and CFTC respectively. Schapiro is unique in that she has been a commissioner at both regulators, which should make it easier for them to work together. Gensler was the then-Treasury Secretary Lawrence Summers’ aide, who worked on the original flawed CFMA legislation. The act has to be reformed now and Gensler understands its nuances.
Fortunately, the administration’s proposals are generally similar to those sketched out by some key Congressional figures recently, which suggests their passage through Congress should be relatively smooth.
How smoothly the SEC/CFTC division of powers will work in practice is another matter. A lot is at stake.
Related links:
The pricing-clearing link – FT
Regulating derivatives – FT Lex
Wall Street makes significant concessions on OTC derivatives – FT Alphaville
Central counterparties and CDS risk, a contrarian argument – FT Alphaville