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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.
Waldman says the important elements of OTC regulation are defining who is a major swap participant and how broadly the net of comprehensive regulation will be cast. “My guess is, it will be fairly narrow. It will cover the dealers and large financial players who are in the market all the time, taking large positions and not for hedging purposes.” The other part of the debate is how much of the clearing business should be forced onto exchanges. “[Many] people support [clearing], but you have a lot more people saying there shouldn’t be an exchange-trading mandate. They feel exchange trading is going to increase their costs. A lot of folks do their business bilaterally in the OTC market for a reason.” He says “spring is ambitious” for completion of final legislation.
The CFTC’s recent proposal for position limits in energy came with reservations from CFTC Commissioners Michael Dunn, Scott O’Malia and Sommers. Sommers had reservations that hard limits may be imposed on exchange trading without similar limits in place for OTC markets. She also said without global standards, trading could move to other financial centers around the world. She says it’s likely that changes will be made to the proposal after the comment period closes at the end of April, but, “There’s nothing you can do about some of our major concerns without legislation, without giving us the authority for jurisdiction over the OTC markets, without other global jurisdictions moving in the same direction.”
On whether the CFTC will wait on its proposals until Congress finishes its OTC legislation, she says, “It’s hard to predict time schedule for legislation and I don’t think that’s the Chairman’s intent.”
Brown-Hruska supports the CFTC’s authority to set position limits but says they should do it with the assistance of the exchanges to come up with optimal levels that are minimally invasive for the market. “Position limits should be used sparsely and only in those conditions where you’re concerned about supply and demand imbalances. Now they think they can use them to curtail speculation [and] manipulation. What it really does is curtail legitimate trading. If you try to limit position size in the middle of a contract month, you’re simply creating a special set of circumstances that limit a trader’s flexibility and their ability to put on optimal hedges and take positions,” she says. Peterson doesn’t believe that position limits will force trading overseas. “[Big banks] should be subject to the same position limits as speculators,” he says.
There are two additional proposals that many in the industry say are long shots for passage, the Volcker rule and efforts to end 60/40 tax treatment for traders. The Volcker Rule, proposed by President Obama in January and named after former Federal Reserve Chairman Paul Volcker, would ensure no bank or financial institution that contains a bank will own or sponsor a hedge fund or private equity fund or proprietary trading operations unrelated to serving customers.
Brown-Hruska says the Volcker rule is an “effort to disenfranchise Wall Street of the provision of liquidity and the extension of credit. The financial industry has always been the lynch pin of our economic success. There were mistakes made, there was a financial crisis, but you don’t come back and cut off your nose to spite your face because it can only go badly.”
Waldman says the Volcker rule is not likely to pass because its timing was off. “Had they put it out with the rest of their proposals, they might have been able to get it through. [Putting it out] late in the game, for better or worse, [gives] it a feel of political expediency.”
The Obama administration’s proposal to eliminate 60/40 tax treatment for traders has been floated by the government several times throughout the years. (Under 60/40 tax treatment, 60% of profits and losses are taxed at the lower long-term capital gains rate and 40% of such gains and losses are taxed at the higher, short-term rate.) “The government is starved for cash and traders are not the most popular constituency these days, so I wouldn’t rule it out, but based on history, it never seems to happen,” Waldman says.
Brown-Hruska says taking away 60/40 tax treatment “will have a negative effect on business activity in the derivatives space, so I see it as an affront to the industry and an affront to everything that’s been built to increase the liquidity and proper function of the market.”
It would have a significant international impact because many approved non-U.S. futures do not get the benefit of 60/40. Non-U.S. futures markets approved to trade in the United States still have to get approval from the Treasury Department separately to get 60/40 treatment. Historically only a handful of markets got it and many more didn’t try. The ICE Europe contracts and the NYSE Liffe markets recently passed the bar.
Regardless of when regulatory reform happens or what form it takes, experts agree that traders should be prepared. Make no mistake that politicians are serious about accomplishing reform. And asked how he would respond to traders who say new regulations could impede the way they do business, Peterson says, “it will affect the way they do business, and it should. Our economy got built up based on all of this money, and it was a false economy, and now we’re getting down to a real economy. To get to the real economy, it’s going to mean less business [for traders and banks]. They’ll survive.”
Brown-Hruska says traders are underestimated by Washington as to their importance in markets. “The populists aren’t trying to appeal to the trading community. We need to see the positive benefit they have to commercial hedgers, to farmers, to airlines. Somebody has to take losses and gains to make markets efficient. We need that community to come forward and have a voice here.”
Waldman agrees. “Traders need to follow developments carefully. Even if legislation doesn’t go through at all, you’re clearly going to see new regulations out of Washington. It’s going to become a more regulated business,” he says.
Sommers says that the CFTC is mindful of traders’ concerns. “The business is electronic and moving that sort of liquidity to other exchanges globally is something that can be done with relative ease. We have to be very careful when imposing new rules and regulations because the last thing I would want to see is us creating some sort of regulatory arbitrage between jurisdictions. I doubt any regulator would tell you they have much of a different goal than the traders do. We all want the same things — to have healthy, vibrant markets.”
Throughout the process, CFTC Chairman Gary Gensler has stated that he is working with international regulators. To what extent they embrace some of the recent rule proposals will play a huge part in what comes out in the end. Despite tough rhetoric, it is unlikely that the U.S. Congress will pass legislation that will push trading overseas, so to what extent these become global solutions will determine if they come to pass.