The question of where credit default swaps (CDS) will trade and who will regulate them has yet to be determined, but potential players made their case and spoke of the role of credit derivatives in the U.S. economy at a Dec. 8 hearing before the House Agriculture Committee.
On Nov. 14, the President’s Working Group on Financial Markets (PWG) announced initiatives on OTC derivatives oversight. “It is important for regulators to continue to focus on ways to promote the robustness of the OTC derivatives infrastructure,” says Greg Zerzan, head of public policy at the International Swaps and Derivatives Association.
The PWG’s initiatives included a memorandum of understanding (MOU) between the Federal Reserve, Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to promote more consistent regulatory oversight.
CFTC Commissioner Michael Dunn said in a statement that the MOU “does not describe the operational processes that are to be utilized in the sharing of information between parties [and] does not alter the existing jurisdictions of any of the respective signatories.” Commissioner Bart Chilton dissented from the MOU, saying, “CFTC is the expert federal financial oversight regulator for clearing derivative products.” He added that other regulatory bodies do not have similar levels of expertise in this area.
Philip McBride Johnson, former CFTC chairman, says that the CFTC should regulate CDSs because of that expertise. He says the agency could more easily create a regulatory framework and already has safeguards in place to monitor CDSs. “Swaps are either futures or event options that, but for the Commodity Futures Modernization Act (CFMA), would fall clearly within the CFTC’s existing jurisdiction,” Johnson says. The CFMA of 2000 put regulatory authority for swaps outside of the jurisdiction of both the CFTC and SEC.
CME Group, the Intercontinental Exchange (ICE), NYSE Euronext and Eurex all have proposals in the works for central clearing facilities for CDSs. ICE received clearinghouse approval on Dec. 4 from the New York State Banking Board, but as of press time ICE still needed approval from the Federal Reserve Bank of New York, while CME Group and ICE both needed approval from the SEC to move ahead with their CDS clearinghouse efforts.
In testimony given at the Dec. 8 hearing, CME Group Executive Chairman Terry Duffy explained CME’s decision to use its own clearinghouse to back CDS trades. “We took great care to ensure that the risk profile faced by non-CDS participants is not adversely affected. The risk profile to the guaranty fund posed by a CDS product is comparable to that posed by a traditional futures product,” Duffy said.
In written testimony, Johnathan Short, general counsel of ICE, said, “The best solution for containing the financial risks associated with credit derivative markets is to completely separate them from other derivative markets. ICE’s solution can quickly address the existing systemic risk that is resident in the market.” ICE’s proposal would create a separate CDS clearinghouse, ICE US Trust, to back its trades.
Congress got into the regulation melee when Sen. Tom Harkin (D-IA) introduced the Derivatives Trading Integrity Act, which aims to put all OTC derivatives, including CDSs, on exchanges. The proposal amends the Commodity Exchange Act to eliminate the distinction between excluded and exempt commodities and regulated, exchange-traded commodities.
“Right now, the swaps community has a chance of defeating just about any proposal and has already indicated that it will try,” Johnson says.
On Nov. 11, CFTC Acting Chairman Walt Lukken, who steps down in January, proposed a three-pronged objectives-based regulatory system consisting of a systemic risk regulator, a market integrity regulator and an investor protection regulator. The functions of the CFTC, SEC and banking regulators would be dispersed among the three regulatory authorities. Lukken did not support an SEC-CFTC merger, saying it “would be ineffective and would only reinforce our outdated regulatory structure.” Speaking at an industry conference on Nov. 12, Duffy said, “The new administration…is going to be focused on things that are broke. I don’t see them going after merging [the SEC and CFTC].”
Johnson does not think a new regulator will emerge. “Being in a ‘damage control’ mode, Congress is far more likely to find a logical home for the troublesome instruments from among the existing agencies,” he says.
