Thursday, October 8, 2009

Regulators seek tighter restrictions in OTC derivatives legislation

Posted on FinReg21 by Darrell Delamaide:

Regulators testifying at a congressional hearing sought some tightening up of proposed legislation on over-the-counter derivatives to avoid opportunities for regulatory arbitrage.

House Financial Services Committee Chairman Barney Frank readily conceded that the legislation was a work in progress and would probably need some tightening based on the recommendations of witnesses at the hearing.

Henry Hu, the first director of the SEC’s newly created Division of Risk, Strategy and Financial Innovation, warned the panel that the setting of two different standards of regulation for swaps on the one hand and securities and futures on the other could leave openings for firms to evade regulation.

“These regulatory differences could perpetuate existing regulatory arbitrage opportunities that encourage the migration of activities from the traditional regulated markets into the differently regulated swaps market,” Hu said.

To counter this, Hu continued, Congress should amend the bill so that all swaps that referenced securities would be regulated by the SEC like securities and those that referenced commodities and other non-security derivates would be regulated by the CFTC like futures.

On the other hand, Hu suggested that the SEC was not so keen on the bill’s provision granting it and the CFTC authority to ban certain types of products. He proposed that Congress consider giving this authority to a more broad-based entity like the Financial Stability Oversight Council.

Hu drew attention to other areas where the language of the legislation could be tightened – such as including a narrower definition of “swap” and also a more precise limitation on who would be exempted from regulation because they use derivatives for “risk management.”

He suggested that credit default swaps based on a broad equity index should be classified as securities and subject to SEC supervision, not just those based on a single security or a narrow index.

CFTC Chairman Gary Gensler also cautioned that too broad a definition of risk management as a reason to exempt participants from supervision could result in a large number of entities evading regulation.

Gensler also insisted that trading on regulated exchanges or regulated trading platforms should be required for all cleared swaps, and not merely made available as the draft bill has it.

“Market participants and the public would benefit greatly from the transparency and better pricing afforded by regulated exchanges and trade execution facilities,” Gensler said.

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