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.