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After the financial crisis of 2008, all eyes around the trading world came to focus on one place: Washington, DC. And after almost two years of regulatory uncertainty and proposals from Capitol Hill and the Commodity Futures Trading Commission (CFTC), Washington finally could be ready to pull the trigger on derivatives regulation. Regardless of what form new regulations take, they are coming and traders should be prepared.
The CFTC’s proposal to limit leverage for OTC forex firms to 10-1 from 100-1 on Jan. 13 resulted in a cacophony of negative reaction from the U.S. trading community. The Foreign Exchange Dealers Coalition, a group of the nine largest forex firms in the industry, says limiting leverage would drive the industry into the hands of foreign competitors, resulting in job and revenue losses in the multi-billion dollar U.S. forex industry, along with widespread fraud.
The CFTC’s current proposal comes after the agency’s long history of dealing with forex fraud. “In the division of enforcement at CFTC, they will say this has been their biggest headache for 20 years and you’re seeing a reaction to that and maybe an overreaction,” says Daniel Waldman, partner at Arnold & Porter LLP and former general counsel at CFTC. “It may be that they don’t feel they have the resources to really regulate this market adequately. There’s a good segment of folks [at the CFTC] who would like to see it shrink. In terms of the real retail market, the government’s view is that there’s too much leverage in the system for a lot of retail people.”
Sharon Brown-Hruska, former CFTC chairman and current vice president in NERA’s securities and finance practice, says the agency wants to ensure retail customers have to put up more capital to avoid risk, which is understandable, but the current proposal’s 10-1 leverage number overshoots the mark and could actually damage legitimate trading.
“The goal is not to kill the market. That’s not how you solve a fraud problem. You do your best to give your enforcement agencies the resources to find it and snuff it out but you [want to] be careful that your regulatory restrictions don’t crush the trading,” she says.
House Agriculture Committee Chairman Collin Peterson (D-MN) says of the proposal, “I don’t know what CFTC is trying to accomplish. Such a restrictive limit [could] encourage investors to move their money to less restrictive overseas markets with fewer consumer protections. CFTC needs to strike a better balance, so that reasonable transactions can continue with improved reporting and oversight.”
CFTC Commissioner Jill Sommers says, “There’s always going to be parts of a proposal that the industry has concerns about and that’s the purpose of putting something out for comment.”
Statutory obligations for the CFTC to write rules in this area came in May 2008 with the passage of the Farm Bill, which included CFTC reauthorization. “Anyone who followed this statute knew that we had to write these rules,” Sommers says. After reviewing the comments, CFTC staff will come to the Commission with recommendations for a final rulemaking, which she says could be “several months away.” The agency will respond to concerns about the proposal after the comment period ends on March 22. She says the evaluation process could take longer than usual because there are more than 6,000 comment letters on this proposal.
Efforts to reform OTC derivatives regulation will have an impact on traders as well. On Dec. 11, 2009, the House of Representatives passed HR 4173, the Wall Street Reform and Consumer Protection Act of 2009, which calls for all standardized swap transactions between dealers and major swap participants to be cleared and traded on an exchange or electronic platform. Peterson, whose Peterson-Frank Amendment to HR 4173 called for the central clearing requirement for OTC derivatives, says, “the way our legislation is crafted right now, 70%-80% of [OTC derivatives] will be standardized.” He says OTC market regulation is the most important regulatory issue at the moment, along with making sure banks have adequate collateral. “The OTC market is so huge and it’s got to be brought out in the open.”
Peterson says that the completion of Senate legislation will depend on a compromise about the creation of a consumer protection agency, which has caused conflict within the Senate. There are rumors that the Senate will drop the consumer agency idea, and Peterson says the agency is “not necessary” and consumer protection can be carried out within existing agencies.
Sommers agrees that derivatives legislation has been slowed down because it is tied to more controversial legislation like the consumer protection agency proposal and because two committees in the House and Senate, Agriculture and Banking, both have jurisdiction. “The more time that passes, the harder it gets to be optimistic,” she says.
Industry insiders say that whenever legislation is passed, it will shake up the market. “To think you can impose a regulatory structure onto the over-the- counter markets overnight and make it work and not have a lot of dislocation is naive and a bit scary to me. I’ve always had concerns about a vertical exchange model [where an exchange controls the trading and the clearing]. I don’t want to see government create a monopoly in a clearinghouse,” Brown-Hruska says.