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SEC vs. House on OTC Derivatives

OCT 7, 2009 6:47pm ET
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WASHINGTON — A Securities and Exchange Commission official asked a congressional committee yesterday to strengthen its draft bill to regulate over-the-counter derivatives so that all securities-based swaps are treated as securities. However, the request was met by resistance from the panel’s chairman and another regulator.

Henry Hu, director of the SEC’s division of risk, strategy, and financial innovation, warned the House Financial Services Committee that its proposed derivatives bill would provide opportunities for “gaming” the regulatory system because the Commodity Futures Trading Commission would regulate swaps based on a broad-based index of securities while the SEC would only oversee swaps based on a narrow-based index of ­securities.

His remarks came after the committee released a “discussion draft” of a bill last week that calls for such a distinction, mirroring the proposal the Obama administration made earlier this year.

Both bills would authorize the CFTC to regulate swaps in the muni market that are based on the Securities Industry and Financial Markets Association’s bond ­index, which is broad-based.

Hu said the distinction makes little sense in light of the “arbitrage possibilities” that could allow a market participant to use a broad-based swap “to gain highly targeted exposure to a single company or a narrow group of companies.”

“Simplifying things, to treat for instance all securities-based swaps as securities, and falling within the parameters of the federal securities laws ... reduces the possibility of gaming, gaps, and facilitates more efficient responses,” he said.

In written testimony, Hu said the SEC’s concerns are compounded if security-based swaps are not considered securities under both the Securities Act of 1933 and the Securities Exchange Act of 1934. While the draft legislation revises the 1933 act to include “security-based swaps” in the definition of “security,” it does not make a corresponding change in the 1934 act, he said.

But Hu’s push for a “simplified” system was subtly rejected by both Gary Gensler, the CFTC chairman who testified on the same panel, as well as chairman Barney Frank, D-Mass.

“We think that the administration’s proposal and the discussion draft got this right and ... kept in line the 27-year arrangement where broad-based indices and futures ... are regulated by one market regulator” — the CFTC — “and narrow-based by the SEC,” Gensler said, referring to the Shad-Johnson Accord of 1982. The accord signed by then-SEC chairman John Shad and then-CFTC chairman Phillip Johnson outlined the commissions’ jurisdiction over futures.

Hu tried to respond, but Frank said there was not enough time. “There’s an interagency issue here, and we will have to move on,” he said. “I will have to tell the SEC that you are up against a pretty high hill if you’ve got the administration and the agriculture committee on one side.”

In his opening remarks, Frank said the draft bill “will and should undergo significant change” before it is voted on possibly later this month, though he was not referring to any specific provisions. He added that it could be signed into law by President Obama in December, though he conceded that assumes “the most ambitious timetable.”

One lawmaker said he believed the SEC should have increased oversight over securities-based swaps, particularly those that are entered into by municipalities.

Rep. Dennis Moore, D-Kan., said: “There are some items related to municipal swaps that should clearly remain under the jurisdiction of the SEC in order to be covered by the increased protections for muni securities and advisers that are coming under the SEC and other parts of regulatory reform.”

Moore also asked the panelists for their thoughts about “the unique nature of municipal finance that often require [issuer] contracts to be more customized.”

Hu did not directly respond to the request, but said that municipalities most directly relate to the legislation “in the area of business conduct.”

“One of the areas that we think may be appropriate would be in fact enhancing the business conduct requirements with respect to less sophisticated participants, some of whom may be municipalities,” Hu said. “We have real concerns about that. We’ve seen issues involving municipalities and their derivative activities that concern us.”

He also called for Congress to consider “raising the qualification standards for a governmental entity or political subdivision — such as a municipal government — to qualify as an ECP,” or eligible contract participant for OTC derivatives.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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