The Securities and Exchange Commission met today and voted unanimously to propose the final set of rules it is required to promulgate under the Dodd-Frank Act. Given the recent blowup over SEC Chairwoman Mary Schapiro’s proposal for stronger regulation of money market mutual funds, the very act of meeting was something of an accomplishment. Getting this proposal out the door will make it easier for Schapiro to declare “Mission Accomplished” and proceed with the next phase of her life.
The technical title of the proposal is “Capital, Margin and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers.” This massive, complex regulation is just part of a set of regulations proposed by an array of financial regulators. Most of the regulations come under the jurisdiction of the Commodity Futures Trading Commission (CFTC), which completed part of its agenda before stalling out because CFTC Chairman Gary Gensler lacked majority support on the five-member commission, even though the Democrats control three seats. The regulations the SEC considered today relate to swaps based on securities, and the banking regulators have jurisdiction over some aspects of the conduct of derivatives activities by banking entities. Today’s meeting made clear that on some common issues the SEC and CFTC are proposing different approaches. Some of these differences are due to the differences between the products, but others reflect philosophical differences and constituent pressures. Also, contact with customers regarding swaps and futures regulated by the CFTC is often through futures commission merchants (FCMs), whereas for security-based products regulated by the SEC, it is through broker-dealers, and they have different regulatory schemes.
The requirements for segregating funds also differ between the SEC and the CFTC, with the SEC’s regulation of broker-dealers offering considerably more protection than is offered by the CFTC through its regulation of FCMs. This issue came to the fore in the wake of the MF Global and Peregrine scandals, where thousands of customers of FCMs lost access to funds they assumed were protected. And it was further complicated by the fact that MF Global operated as both a broker-dealer and an FCM, leading to confusion over how much protection customers could expect. Legislation affecting the respective entities falls under the jurisdiction of different congressional committees. It appears that even after the scandals, the futures community maintains a higher tolerance for the commingling of funds and for allowing the FCMs to invest these funds than exists on the securities side with respect to broker-dealers.
Experience with the ongoing financial crisis has raised awareness of the importance of capital and liquidity rules, as well as the calculation of valuations of assets that could be posted as collateral for derivatives positions. The regulation is complicated by the so-called “end-user exemption,” which promises a free ride to customers, such as politically powerful farmers and ranchers who use derivatives for hedging of their agricultural operations. The proposal provides opportunities for firms to choose whether to use a leverage ratio or an internal model to determine required capital, and as was in 2008, it appears that a significant advantage can be obtained by using internal models. There will also be an opportunity to choose whether to conduct derivatives activities through a nonbank or an affiliate of a bank holding company, which implies a different regulator, depending on the preference of the firm. Thus, some of the same disparities in treatment that contributed to the financial crisis will probably continue to exist under these regulations. The SEC has requested public comment on these and five hundred other questions, and it has asked that data be submitted to support the views of the commenters.
Finally, there was considerable discussion at the meeting of how these rules will be applied in a global setting, a so-called “cross-border application.” A prominent political theme of the industry has been that U.S. firms could be placed at a competitive disadvantage, activities will move to London and jobs will be lost in the United States. There is also concern over the length of time it takes to reclaim funds of American investors if their funds get tied up in bankruptcy proceeding in the United Kingdom, as was the case with the bankruptcy of Lehman Brothers and is likely to be repeated with MF Global. The SEC staff has promised to produce a document laying out the cross-border issues so they can be resolved comprehensively in discussions with counterparts in the United Kingdom. However, this promise needs to be considered in light of remarks made earlier this week by Simon Johnson at the Milken Institute that no meaningful progress has ever been made in creating the kinds of cross-border arrangements that would be needed in order to liquidate large institutions when they fail, and Johnson predicted that no progress would be made during the careers of anyone in the room.
On balance, the adoption of another rule under Dodd-Frank offers little assurance that the next crisis will be, as Johnson and the leaders of the Federal Reserve Bank of Dallas have predicted, an even larger version of the bailouts of 2008.
Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.
Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.
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