Tags: CFTC | SEC | derivatives | regulations

Capital Markets Subcommittee Reviews Derivatives Regulations

By Robert Feinberg   |   Wednesday, 12 Dec 2012 03:38 PM

The House Financial Services Committee’s Capital Markets and Government Sponsored Enterprises Subcommittee, chaired by Rep. Scott Garrett, R-N.J., spent four hours listening to two panels of witnesses regarding the state of the efforts of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to adopt regulations to implement the derivatives provisions of the Dodd-Frank Act, hurriedly drafted in the summer of 2010 and supposed to be implemented a year later.

The first panel was composed of CFTC Chairman Gary Gensler and Robert Cook, director of the SEC’s division of trading and markets. Cook was substituting for SEC Chairman Mary Schapiro, whose term is expiring, and Cook himself will be leaving the Commission at the end of the year.

The purpose of Title VII of Dodd-Frank is to subject over-the-counter (OTC) derivatives trading to clearing, so that the market can be made transparent, more competitive and less risky. Overall, 95 percent of this business falls under the jurisdiction of the CFTC, with only the security-based swaps portion regulated by the SEC. Thus, most of the questions were directed at Gensler, with questions asked of Cook mainly where they were likely to cast the rulemaking process of the CFTC in an unfavorable light.

The second panel was composed primary of industry association witnesses who complained that the CFTC is going beyond the intent of the Dodd-Frank Act in the extra-territorial application of the regulations. Gensler insisted that unless the rules are broadly applied, there will be repeat occurrences of companies like AIG, which figures prominently in the 2008 crisis that gave rise to the enactment of Dodd-Frank by conducting risky activities in London, beyond the authority of U.S. regulators, that would ultimately be bailed out by U.S. taxpayers. At the same time, huge risks embedded in U.S.-issued mortgage-backed securities were transferred to overseas investors, and some of these were also bailed out by U.S. authorities.

Much of the impetus for the hearings comes from so-called “unintended consequences” of the regulations. In order to avoid the prospect of having to register with U.S. regulators, market participants in the United Kingdom and the European Union have withdrawn much of their trading activity with U.S. entities.

Also, in order to avoid stricter regulation of swaps versus futures, much of the trading in cleared swaps moved almost instantly, over a single weekend, from the swaps market to futures products that are practically equivalent in their economic effect. Evidently Congress underestimated the ability and willingness of traders to do this, but John Parsons of MIT’s Sloan School confirmed that arbitrage between these markets will occur quickly over even very small perceived differences in regulatory cost.

Samara Cohen, a managing director at Goldman Sachs, summarized regulations singled out for attack by the critics:

1. The sweeping approach to defining the CFTC’s jurisdiction, leading U.S. traders to reduce the amount of trading they will do with U.S. entities.

2. The breadth of the definition of “U.S. person” could cause overlap and conflict between U.S. and EU regulations.

3. Compliance is being required before rules are adopted to establish which entities are subject to rules, such as those requiring registration.

4. Lack of coordination with non-U.S. jurisdictions, which could cause U.S. swap customers to take business overseas.

The CFTC has responded to some of the complaints by issuing guidance and no-action letters to give trading entities more time to comply, but the industry complains that the relief has come at the 11th hour.

Gensler responded that it is the nature of the work that the legislation is imprecise, was written at the last minute and that adjustments are also made at the last minute. Legislators challenged Gensler’s claim that he has been working closely with the foreign regulators by reading correspondence from them saying: “Washington, we have a problem.”

Gensler responded that this is part of the process of reaching an understanding, given that the various regulators have different statutes, regulations and timetables.

End-user representatives have protested the application of margin requirements to some of their trades on the ground that they were supposed to be exempt from the Act and their use of standard derivatives reduce risk rather than compound it. Parsons responded that the transactions unavoidably entail credit risk, and margin should be charged.

Gensler stated, as he has many times before, that the CFTC is not working against a clock, but is engaging in thoughtful regulation. Therefore, regulations that were supposed to be adopted by the end of the year are now expected to slip to at least January or February.

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Robert-Feinberg
The House Financial Services Committee’s Capital Markets and Government Sponsored Enterprises Subcommittee spent four hours listening to two panels of witnesses regarding the state of the efforts of the CFTC and the SEC to adopt regulations to implement the derivatives provisions of Dodd-Frank.
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