Upon the anniversary of the Lehman Brothers bankruptcy — the event many measure as the beginning of the current financial crisis, though it more accurately could be described as the moment the crisis could no longer be ignored — nothing is settled except for the general understanding that more regulation is on the way.
The Obama Administration’s proposal calls for “harmonization” of the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC), requires standardized over-the-counter (OTC) derivatives, including credit default swaps (CDS) to be centrally cleared and traded on exchanges, requires higher capital and margin requirements for non-standardized OTC derivatives and calls for a systemic risk regulator to oversee it all. The latter also is part of the European overhaul (see “Regulating a continental structure”). Complicating this is the evolving and increasingly interconnected nature of global futures, securities and options markets and the clearing structures that support them (see “New world disorder”). Click here for "New world disorder" chart.
The most recent piece of legislative language based on the proposal was delivered to Capitol Hill in August, resulting in the Over-the-Counter Derivatives Markets Act of 2009. On Oct. 2, House Financial Services Committee Chairman Barney Frank circulated a discussion draft of the bill. The draft of the legislation appeared to expand some exemptions to mandatory clearing by end users according to initial analysis, which would likely face challenges.
HARMONIZATION
Industry leaders met with CFTC and SEC commissioners on the agencies’ harmonization efforts in September. In his testimony, CME Group CEO Craig Donohue warned that “merger of the existing regulatory structures into a single set of one-size-fits-all rules administered by separate agencies will do substantially more harm than good.” Options leaders including Chicago Board Options Exchange Chairman Bill Brodsky and Options Clearing Corporation Chairman Wayne Luthringshausen called for a focus towards the CFTC’s principles-based approach vs. the SEC’s rules-based approach to regulation. Several panelists cited past regulatory stalemates that resulted in delays for the introduction of new products such as credit default options and options on gold and silver ETFs.
“One of the questions we think about is whether this [harmonization] approach will work over the longer term as new products and new participants come into the market that they haven’t thought of during these harmonization discussions,” says Gary Katz, President and CEO of the International Securities Exchange. “Instead, we would like to see a risk-based approach to regulation. It’s our hope that as they continue these discussions and think about systemic risk, they focus on the areas in the market that have the greatest risk and potential system-wide impact and don’t take a one-size-fits-all approach.”
Gary DeWaal, general counsel for Newedge, says “Ideally, there should be the creation of a single financial regulator. That’s not going to happen, so the next best thing is greater harmonization.”
Susan Milligan, senior vice president of government relations for the Options Clearing Corporation, says if the SEC moves in a principles-based direction, there are routine rule approvals that would move much more quickly. She adds that one of the positive effects of harmonization for traders would be speedier product approvals. “Options on the gold ETF took three years to come to market. People wanted to trade them and couldn’t.”
Katz agrees. “If the SEC adopts the more CFTC-like approach to product approval and exchange rule filings, then traders and customers would have more choice — we would be able to introduce new products more quickly, and that would be very beneficial in this environment,” he says.
Richard Strait, managing partner of Richard Strait, LLC, a guaranteed broker to Triland USA, says “Securities markets are miles behind the futures markets with regard to clearing of risk. For the financial futures that are coming onto the marketplace from the OTC side, the SEC is going to have to formulate their policy [to make it] more in line with what the CFTC does.”
Efforts to move towards portfolio margining across products — something the regulators have struggled to work together on — also are part of the harmonization discussion. Options experts say that current rules, as well as the current account minimum for portfolio margining of $100,000 make it difficult to effectively use an account that has futures and equities and equity options. “Our customers are still handcuffed by margin rules that don’t take into account the sophistication of the products,” says Peter Bottini, vice president of trading at optionsXpress. “Securities margin requirements are very outdated and very inappropriate for customers who are using complex strategies.”
Milligan says, “If customer portfolio margining, which includes both futures and securities, could finally happen, that could be a really
positive development.”
CLEARING THE AIR
The blueprint’s calls for all OTC derivatives to be centrally cleared and put on exchanges would be a significant change for the industry and has been the focus of most of the Congressional hearings to date. Calls for OTC reform were preceded by exchange efforts to clear CDSs in early 2009. The Intercontinental Exchange (ICE) now clears credit default swaps through ICE Trust. As of early October, ICE Trust had cleared $3 trillion across 22,000 transactions in North American CDS indexes with open interest of $187 billion. CME Group had planned to clear and trade CDSs through a joint effort with Citadel called CMDX, but restructured its clearing effort in September to focus on clearing-only services.
“If standardized OTC derivatives were cleared, that would probably be a positive for end users. Once you’re on exchange, there’s a lot of transparency, there’s generally way more liquidity,” Milligan says.
However, DeWaal says that clearinghouses that are not subject to CFTC or regulated capital requirements are not necessarily the panacea that the regulators think they might be. “It sounds great to push OTC products onto exchanges, but there’s a lot of devil in the details. Those details need to be fleshed out before we can assess if this model could work. The ICE Trust system is a very closed system, it’s not very transparent, and according to the Fed, it’s very risky. If you’re not adding financial strength and you’re not adding transparency, I’m not sure what the benefit is,” he says.
Gurpeet Banwait, product manager at FINCAD, says CME Group’s CDS restructuring might be a good move for them if the market is not ready to move to a centralized clearing model. “The idea of doing centralized clearing is a good one in principle, but the key is going to be, how do you clear contracts? If these standardized contracts are not very liquid, the centralized clearing model will probably fail, unless you’re regulated to put everything through to a clearinghouse or subsequently through to an exchange,” he says.
Strait says that putting OTC derivatives on exchanges will increase overall volume, increase transparency and increase liquidity, but the traditional OTC market maker could suffer. “OTC market makers probably [won’t] get as much profit out of each transaction because the effect of increased liquidity narrows the bid-offer spread. The increased liquidity is going to make the markets more efficient. Efficiency is great for the overall marketplace but not necessarily good for the traditional OTC market maker.” However, he notes that from the average trader’s perspective “cleared OTC products are going to be a boon to their ability to access markets that some were not able to get into.” For example, he notes that CTAs will now be able to be involved in this marketplace, which is an overall benefit.
Milligan says regulators are on the right track with clearing, as clearinghouses on both the securities and futures sides performed well during the financial crisis, but she notes that derivatives that are very customized, or have extremely low volume, should not be forced onto a clearinghouse. “There’s not a lot of benefit from clearing them. If they’re hard to price, they would be hard to liquidate, so a clearinghouse may not add a lot in terms of risk reduction,” she says.
DeWaal says there could be economic problems associated with OTC clearing. “Potentially, there’s not a lot of economic incentive to clear CDSs or any OTC product because they tend to be traded in hold positions, so the model of charging a relatively nominal commission may be unattractive for the brokers. It’s the same issue at the clearing level. Issues about how the assets associated with these positions will be handled need to be resolved.”
In a letter to G-20 leaders on Sept. 21, Brodsky, in his position as chairman of the World Federation of Exchanges, said “More standardization of OTC contracts should lead to exchange trading of these instruments. For this to happen, however, capital rules for banks and broker-dealers should recognize a reduced capital charge or haircut for transactions traded on an exchange and cleared in an independent, multilateral clearing house.”
The Oct. 2 draft, however, did not include language that required OTC transactions to be executed on an exchange or electronic clearing facility. As far back as March 2007, former Federal Reserve Chairman Alan Greenspan expressed shock at the archaic way some OTC credit trades were transacted.
Sharon Brown-Hruska, former CFTC chairman and vice president for NERA Economic Consulting, says some users could be displaced because of higher margin costs and capital requirements for OTC clearing. “This forced standardization will make uneconomical a number of hedging transactions that would have taken place that intermediaries usually do in the OTC space. Clearing of OTC products is great and I’m in favor of it, but what should be cleared and what is a minimum for clearing should be market-determined, not a government mandate that says ‘everything must be cleared.’ The stated goal of making it too costly to trade customized derivatives is really heavy-handed. Their goal is to encourage clearing and the result is to discourage their use, and it shows a lack of understanding of the products and the markets themselves,” she says.
POSITION STATEMENT
The CFTC shone the spotlight on speculators in July and August with its hearings to address the application of and exemptions from position limits in the energy markets. In his statement before the CFTC, CME Group’s Donohue said that CME Group was prepared to adopt a hard limit regime and the CME has gone about designing one. He also called efforts to control price or volatility by position limits a “failed strategy.” On the hedge exemption issue, Donohue said that “denying or limiting [swap dealers’] access to futures markets will simply impede hedging activity by commercial market participants.”
The CFTC has had greater visibility throughout the process and Gensler has been a familiar sight on capital hill (see “Gensler on the hill”).
DeWaal says trading could move overseas if position limits are imposed. “I’m not convinced that foreign regulators would not tolerate local exchanges offering products that parallel the U.S. markets. If that happens, you [could] see migration of some liquidity,” he says. “Everyone’s saying ‘let’s push OTC products to exchanges and clearinghouses to improve transparency,’ but at the same time we [could be] starting on a path that could push commodity products into a less transparent environment, at least from a U.S. perspective.”
Banwait says that imposing position limits could have the unintended consequence of making it impossible for some traders to hedge away risk.
Another regulatory change involves net capital requirements for FCMs. In May, the CFTC proposed adjusting net capital requirements for FCMs, amending the minimum dollar amount of required annual net capital to $1 million from $250,000 and amending the FCM capital computation to increase the acceptable percentage of the total margin-based requirement for futures, options and cleared OTC derivative positions in customer accounts to 10% from 8%. Both the Futures Industry Association (FIA) and National Futures Association (NFA) support the raising of required net capital to $1 million, but oppose the increase in margin-based requirement percentage. In a comment letter to the CFTC, NFA said “we question the efficacy of this rationale. During the past year’s significant market volatility, there has been no evidence that the current risk-based capital requirement has failed or has placed FCMs in precarious financial situations.”
It is one of several new rules or recommendations that industry insiders say is aimed at the part of the system that worked as opposed to what caused problems.
WHAT’S NEXT
It’s difficult to predict when or if these regulatory reforms will actually be put into law, with some saying that Washington’s more intense focus right now is on the healthcare debate.
Milligan says that it’s unlikely that anything will become law before next year.
“I think we’re going to see something by the spring,” says David Matteson of Drinker Biddle & Reath LLP. “Any time you re-allocate responsibility and jurisdiction, you’ll get into a turf battle, and people don’t like giving up turf, particularly the House and Senate committees that have jurisdiction over the commodity and securities markets. That’s what’s slowing it down.”
DeWaal says if the proposals are not enacted by the end of March, it’s going to be hard for anything to happen next year because it’s a reelection season. “Some things can happen without legislation, like position limits, but the things that require legislation, if nothing happens by end of March or April, we’re not going to see anything until 2011,” he says.
Discussion drafts of the Treasury department’s proposal for OTC derivatives regulation were done by the House Financial Services Committee on Oct. 2 and the House Agriculture Committee on Oct. 9. The drafts differ in their definition of a swap or security-based swap. The Financial Services Committee’s draft exempts foreign exchange swaps from the bill’s provisions, while the Agriculture Committee’s draft includes foreign exchange in the definition of a swap and excludes foreign exchange forwards from the definition only under certain conditions. While the Financial Services Committee’s draft does not have a trading requirement for swaps/security-based swaps, the Agriculture Committee’s draft and the Treasury’s proposal say that all swaps/security-based swaps that are cleared must also be traded on exchanges. While neither the Treasury proposal nor the Financial Services Committee’s draft addressed position limits on futures contracts, the Agriculture Committee’s proposal called for the CFTC to set position limits on futures contracts for physically delivered commodities and redefined who is eligible for hedge exemption and can exceed position limits.
Frank pointed out there likely will be significant changes in the draft as the legislation winds its way through the legislative process.
GLOBAL COOPERATION
Regulators and market participants from around the globe got together at the annual Bürgenstock conference in Switzerland this September to try and hammer out common ground.
David Lawton, head of market infrastructure & policy for London’s Financial Services Authority (FSA), says the challenge isn’t in agreeing on what needs to be done, but rather in bringing that agreement into institutional reality.
“The regulatory issues that everyone is beginning to lay out at the top layers are incredibly convergent,” he says. “Everyone agrees on four or five big ideas: namely, that OTC derivatives should be standardized wherever possible, that more should be cleared through central counterparties, that we need more transparency in what’s happening in the market, and that we need to strengthen the capital and other infrastructure arrangements for those derivatives that remain traded OTC.”
The challenge, he says, is in figuring out how best to implement
these strategies.
“Over the next two years, we’ll be putting down details and creating the appropriate structures, committees, and dialogues to match the convergence institutionally that we already see at the top level,” he says.
CFTC Commissioner Michael Dunn agrees, and adds that international cooperation among regulators is nothing new. Citing the adage against letting a good crisis go to waste, he says what’s new is the political will and the broad awareness.
“We’ve got our crisis, and now have a unique thing — namely, that all sectors of society are zeroing in on this — from the top political leaders of the world at the G-20 meeting in Pennsylvania to the guy who cuts my hair.”
He believes that the G-20’s Financial Stability Board (FSB), which was created in April of last year, has gained credence in the wake of the economic crisis and is offering common guidance for regulators around the world.
“All of these efforts cascade down to us at the regulator level, and they are all looking more and more alike,” he says. “Whether you’re looking at multilateral forums like IOSCO or bilateral MOUs like the ones we are putting together with the FSA, you’re seeing that rhetoric is being translated into action everywhere in real time.”
Lawton says the key will be making sure that progress continues.
“The key for the next 12 to 18 months will be to make sure we don’t waste time discussing issues in the wrong forum with the wrong people around the table,” he says. “We need to be asking if we have the right structures in place, whether formal or informal, and if we haven’t, can we quickly create them, and then we get on with using them.”
And the mention of informal structures is telling, for none of the regulators in the Bürgenstock forum felt regulators were out of touch with each other before the crisis. Rather, they were out of touch with certain
disturbing realities.
“We always had these supervisory colleges that are now being promoted as something new,” says Daniel Zuberbühler vice chairman of FINMA. “But the trouble is that if you are collectively blind, even sitting around the table is not going to help you. We have to become better at recognizing the problem.”
Indeed, while the talk of merging the CFTC and SEC has been hot news in the United States, it’s difficult to find anyone abroad who feels that should be a major focus of discussion, even though nearly all jurisdictions have merged their securities and derivatives regulators into one entity.
“It doesn’t matter who has responsibility for what as long as the broad regulatory landscape of the United States mirrors generally the broad regulatory landscape in Europe,” says Lawton, whose own agency was formed through the merger of four other entities.
REGISTERING HEDGE FUNDS
On the managed money side, the Managed Funds Association (MFA) had long ago thrown in the towel on preventing hedge fund manager registration as most assume it is a done deal. The MFA and industry leaders are looking to shape some of the changes and prevent those managers who operate as both commodity trading advisors (CTAs) and exempt hedge funds from facing multiple regulatory masters.
David Matteson, partner with Drinker Biddle, says any CTA trading strictly futures would not need to register but advisors involved in both futures and securities would need to register and those only marginally involved in securities also may have to register.
MFA General Counsel Stuart Kaswell says, “MFA supports changes to Section 203(b)(3) of the Investment Advisers Act, which would eliminate the private advisors exemption.” The effect of the change would be to require an advisor to a hedge fund to be registered under the Advisers Act.
Where MFA takes issue is that the proposal also effectively would take away the 203(b)(6) exemption under the Act. That change would require CTAs that may only marginally use securities to register with the SEC. “MFA believes that CTAs that are not primarily acting as investment advisors should not be subject to dual registration,” Kaswell says.
The key is the term “primarily engaged in securities.”
“What does that mean?” asks Matteson. “It would be nice to have some bright lines drawn.”
More recently Kaswell testified on Oct. 7 in support of rules requiring clearing OTC transactions and requiring swap dealer counterparties to hold collateral for OTC transactions in segregated accounts.
Of course some folks have been affected by the Congressionally inspired CFTC push to rein in commodity speculators. Weeks after the CFTC held its roundtable on energy speculation, it pulled “no action” letters from Gresham Asset Management and DB Commodity Services. The letters allowed these entities to surpass spec limits in managing passive long-only commodity investment strategies.
