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Regulations Urged For Over-the-Counter Derivatives

WASHINGTON - Over-the-counter derivatives that are securities-based should be regulated under federal securities laws by the Securities and Exchange Commission, SEC chairman Mary Schapiro told a Senate panel yesterday.

At a hearing on modernizing the OTC derivatives market held by the Senate Banking subcommittee on securities, insurance, and investment, Schapiro said her agency's core mandates of promoting investor protection, fair and orderly markets, and capital formation make it the right regulator to oversee securities-based OTC derivatives.

She also expressed concern about the use of OTC derivatives to "decouple" what are essentially synthetic securities from securities regulation, and called on Congress take make "a limited number of discreet amendments to the statutory definition of a security" to cover securities-related OTC derivatives.

"It is important that securities-related OTC derivatives be subject to the federal securities laws so that the risk of arbitrage and manipulation of interconnect markets is minimized," Schapiro said in prepared testimony.

The regulatory framework would cover "all of the basics of sound financial regulation in the 21st century," she said, including recordkeeping and reporting requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing.

Currently, the SEC only has anti-fraud authority over securities-based derivatives, and Schapiro noted that limits to the commission's authority has made investigations of OTC derivative transactions "far more difficult and time-consuming than those involving cash equities and options."

"The SEC's enforcement efforts have been seriously complicated by the lack of a mechanism for promptly obtaining critical information - who traded, how much, and when - that is complete and accurate," she said.

Schapiro said a derivative is "OTC" if it is not traded on a regulated exchange and "securities-based" if its underlying value references an issuer of securities - such as a public company - or an actual security, a group or index of securities or issuers, or aspects of a security or securities such as price, yield, volatility, dividend payments or value.

She said the Commodity Futures Trading Commission would have oversight over other OTC derivatives, "including derivatives related to interest rates, foreign exchange, commodities, energy, and metals."

Industry participants said that the implications of her remarks on the municipal market are unclear because muni issuers often hedge their debt with different types of interest rate swaps, some of which are generally considered securities-based while others are not.

The SEC has historically treated interest rate swaps based on an index of short-term debt that is set by the Securities Industry and Financial Markets Association as securities-based swaps. It has not included in this category swaps that are based on the London Interbank Offered Rate.

"There are a lot of people that are struggling with that," said one industry observer. "They don't know where Libor swaps go and it's a big issue."

A market participant said there are "obviously significant areas of ambiguity here that will have to be resolved," adding that most market participants would prefer SEC oversight of interest rate swaps because it makes more sense for one regulator to oversee them.

An SEC spokesman declined to elaborate beyond the text of Schapiro's remarks.

Yesterday's hearing comes after the Obama administration unveiled a sweeping financial regulatory reform proposal last week that called for trading all standardized derivatives on central exchanges or electronic execution systems.

Under the plan, non-standard, customized derivatives - including hedging products like interest rate swaps - could still be sold over the counter, but would be subject to federal regulation for the first time.

Last month the administration unveiled a four-point framework for regulating OTC derivatives containing four broad objectives: preventing activities from posing risk to the financial system; promoting the markets' efficiency and transparency; preventing market manipulation, fraud and other abuses; and ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

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