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SEC, CFTC Get Together and Differ

WASHINGTON - The Securities and Exchange Commission and Commodity Futures Trading Commission have different regulatory approaches, which may pose challenges to harmonizing their rules and dividing up oversight of over-the-counter derivatives, market participants and others said yesterday at an historic joint-agency hearing.

Industry officials who testified at the hearing generally called for the SEC, which has prescriptive rules for securities, to move toward the CFTC's "principles-based" regulatory approach for futures, under which it would set forth core principles for firms but give them broad discretion in determining how to meet them.

"This more flexible principles-based approach is used extensively by European regulators," William Brodsky, chairman and chief executive officer of the Chicago Board Options Exchange, testified.

But Mark Cooper, the Consumer Federation of America's research director, said, "Harmonization must not be an excuse for inadequate regulation," and added, "The purpose of this inquiry should be to raise the level of regulation to achieve the ultimate goal, not lower the level to eliminate conflicts."

The hearing comes just two weeks after the Treasury Department released draft legislation that would comprehensively regulate OTC derivatives by dividing jurisdiction for them between the two agencies. The CFTC would regulate most interest-rate swaps, including those in the municipal bond market.

At the hearing, Brodsky noted there is no real mechanism in place to resolve jurisdictional disputes between the two agencies and said this has led to long delays in the decision-making process for new products. He suggested the Treasury initially serve as a "tie-breaker" in such disputes, but said it could later be replaced by the President's Working Group on Financial Markets or a financial services oversight council.

Meanwhile, Eric Baggesen, a senior investment officer for the California Public Employees Retirement System, said that "transparency must be the foremost objective" of any effort to harmonize the rules.

"An unambiguous benefit stemming from organized market exchanges is the reporting of trading activity and pricing to all participants," he told commission officials. "This transparency aspect may be lost in OTC ... trading environments unless provisions are made to insure reporting."

The two different regulatory approaches stem in part from the fact that the SEC is focused on markets that provide capital formation, while the CFTC concentrates on markets that primarily transfer risk, according to Craig Donohue, CEO of CME Group Inc., which operates four exchanges.

Annette Nazareth, a former SEC commissioner and head of the trading and markets division who also spoke at the hearing, said that while Congress pushed the CFTC towards a principles-based regulatory approach in the Commodity Futures Modernization Act of 2000, it propelled the SEC to extend its prescriptive rules-based approach in the wake of the Enron and Worldcom debacles under the Sarbanes-Oxley Act of 2002.

Ideally, she said, Congress should have reconciled the key issues legislatively and merged the two agencies so they could resolve their innumerable differences. But Obama administration officials chose not to do so, primarily because congressional committees did not want to give up jurisdiction.

Nazareth said the two agencies have different approaches to investor-protection standards, customer protection and margining, and insider trading prohibitions as well as fungible products and common clearing. The SEC has long focused on the protection of individual investors, she said, while the Commodity Exchange Act views futures market participants primarily as professionals who are best protected by preserving the integrity of their market.

The SEC and CFTC also differ on how to best protect customers and intermediaries from excessive financial exposure to each other and on the best means to protect customers from the failure of their broker-dealer or futures commission merchant, Nazareth said.

This divergence arises because margins serve different functions in the two systems, while providing the same economic advantage - the ability to obtain leverage in a transaction. In the futures markets, margins guarantee the performance on the futures contract at its termination. In the securities markets, customers must pay the full purchase price of equity securities three days after the trade, though broker-dealers often finance 50%, and over time potentially more of the purchase price. As a result, securities margins involve larger financial outlays with lower leverage.

Nazareth suggested both agencies focus on a "true portfolio-margining system" that encompasses securities, futures, and OTC derivatives. She said that while the federal securities laws prohibit insider trading, the commodities laws generally contain no such ban other than for CFTC and market employees.

The two agencies also take different approaches to competing markets, Nazareth said. The SEC has fostered a system of multiple, highly competitive securities and options markets trading the same securities. The equities clearing agencies merged to form a utility that serves all markets. But futures trade in a single-listing environment. The exchange on which the contract trades controls the clearing of the contract.

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