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Big OTC Reforms Sought

WASHINGTON — Congress must draft legislation mandating broad federal regulation of all over-the-counter derivatives dealers and markets, including municipal interest rate swaps and other non-standardized derivatives products, Commodity Futures Trading Commission chairman Gary Gensler said yesterday.

“We must urgently enact broad reforms to regulate over-the-counter derivatives,” Genlser told members of the Senate Agriculture Committee at a hearing on derivatives.

“The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust federal regulation.

“What we’re talking about is a full shift,” the CFTC chairman said, contending that the derivatives reforms are as important as the reforms that President Franklin Roosevelt asked Congress to adopt for the securities and commodities markets in the 1930s after start of the Great Depression.

“We will be taking action this year,” committee chairman Tom Harkin promised. The Iowa Democrat said he was one of the few committee members that voted against legislation in 1999 to keep the derivatives markets unregulated, as had been urged former Federal Reserve Board chairman Alan Greenspan.

“He said these are smart people and they will self-regulate,” Harkin recalled, adding: “Well, fooled once, your mistake, fooled twice, my mistake.”

While Harkin’s committee only has jurisdiction over the CFTC, industry and congressional sources said yesterday that there is “an emerging consensus between the securities and agriculture committees” on shared jurisdiction of derivatives and a plan for regulating them.

The consensus appears to have developed after the Senate Banking Committee stopped delaying action on Gensler and finally recommended the Senate confirm him to head the CFTC. The idea of a merger between the CFTC with the Securities and Exchange Commission is dead, the sources said.

Gensler yesterday called for “two complimentary regimes” to regulate both OTC derivatives dealers and markets.

Derivatives dealers must be required to meet reporting and recordkeeping requirements that provide an audit trail and business-conduct rules designed to prevent fraud, manipulation and abuse, as well as capital and margin requirements, he said.

The capital and margin requirements would ensure that dealers or counterparties “no longer would ... be able to amass large or leveraged risks outside the oversight and prudential safeguards of regulators,” Gensler said.

Dealers may be required to set aside higher amounts of capital for customized derivatives and derivatives that are less liquid and hard to value, he told the lawmakers.

“The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system, in which some dealers can operate with limited or no effective oversight,” the CFTC chairman warned.

“Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place,” he said.

But regulators should have a clear picture of the derivatives markets and should be able to police and monitor them for fraud and abuse. The public should have access to aggregated information on positions and trades from dealers, Gensler said.

“No longer should the public be in the dark about the extensive positions and trading in these markets,” he said. “The public information will improve the price discovery process and market efficiency.”

Customized derivatives, such as interest rate swaps in the municipal bond market, could be regulated primarily through these dealer requirements, the CFTC chairman said.

Turning to regulation of the derivatives markets, Gensler said that standardized and, to the extent possible, customized derivatives should be required to be cleared through regulated central clearing houses to reduce risk and brought onto regulated exchanges or transparent electronic trading systems to increase transparency.

“There should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared,” the CFTC chairman said. But other criteria could be considered for making such a determination, such as the volume of transactions in the contract, the similarity of terms, and the extent to which terms, including price, are disseminated to third parties.

Harkin said he could not understand customized derivatives and why they cannot be traded on exchanges.

“Individual commercial entities and municipalities sometimes want to tailor a specific product,” Gensler explained. Many of these derivatives cannot be centrally cleared or exchange traded because they are not liquid. An interest rate swap tailored to a specific muni bond issue cannot be traded and used for other bond issues.

However, Gensler warned that Congress should “ensure that customized derivatives are not used solely as a means to avoid the clearing requirement.”  This can be accomplished by giving federal agencies full authority to prevent fraud, manipulation and other abuses and to adopt rules that make clear that dealers and traders cannot change a few minor terms of a standardized swap to avoid centralized clearing and exchange trading. 

 

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