Wednesday, September 23, 2009

Schapiro Asks For Stronger OTC Derivative Regulations, Admits Regulators Failed To Enforce Existing Standards: Do Regulators Ever Ask For Less Regulation?

US Securities and Exchange Commission Chairman Mary Schapiro testified before the House Committee on Agriculture, yesterday, September 22, 2009, concerning the regulation of over-the-counter ("OTC") derivatives and the Over-the-Counter Derivatives Markets Act of 2009, which is a Treasury Department proposal.

Schapiro took the populist approach and partially blamed the financial crisis on derivatives and deregulation. She requested stronger powers to regulate derivatives. She admitted that the regulators failed to enforce existing standards and failed to adapt the existing regulatory framework to the new risks. She was oblivious in her prepared testimony to the obvious contradiction of asking for more regulatory power while failing to enforce the existing rules.

She said in her prepared testimony before the House of Representatives:
The recent financial crisis has revealed serious weaknesses in U.S. financial regulation. Among them were gaps in the existing regulatory structure; failures to enforce existing standards; and failures to adapt the existing regulatory framework and provide effective regulation over traditionally siloed markets that had grown interconnected through globalization, deregulation and technological advances. Fixing these weaknesses is vital, particularly in the current market environment, and it is a goal to which the SEC is absolutely committed.

One very significant gap in the regulatory structure was the lack of regulation of OTC derivatives....
About the Treasury proposal, Schapiro said:
While Treasury's proposal would go a long way towards bringing OTC derivatives under a comprehensive regulatory framework, I believe it should be strengthened in several ways to further avoid regulatory gaps and eliminate regulatory arbitrage opportunities....
The Chairman offered suggestions of several areas that needed more oversight and regulation than proposed by Treasury.

She discussed the areas in need of stronger regulation:
  1. Minimize Regulatory Arbitrage and Gaming Opportunities by Regulating Swaps Like Their Underlying "References"
    Gaming — regulatory arbitrage — possibilities abound when economically equivalent alternatives are subject to different regulatory regimes. An individual market participant can have incentives to migrate to products that are subject to lighter regulatory oversight.
  2. Strengthen Existing Anti-Fraud and Anti-Manipulation Authority
    Treasury's proposal also attempts to retain the SEC's existing anti-fraud authority over all securities-related OTC derivatives, even those securities-related OTC derivatives over which the SEC would not have regulatory authority. This authority is essential to policing fraud in the securities markets; to be effective, though, enforcement also requires: (1) examination authority over entities dealing in securities-related swaps; (2) direct access to real-time data on these swaps; and (3) comprehensive anti-fraud and anti-manipulation rulemaking authority for these swaps.
  3. Credit Default Swaps and Regulatory Arbitrage
    Under current law, the Commission has stated that exchange-traded CDS on securities, whether on one security or a basket of securities, are securities. To avoid gaming by financial engineers under the new regulatory regime, Congress should consider clarifying that the definition of "security-based swap" includes not only single-name and narrow-based index CDS, but also broad-based index CDS, and other similar products, when payment is triggered by a single security or issuer or narrow-based index of securities or issuers. This also would be consistent with the approach advocated above to extend the federal securities laws to all securities-related OTC derivatives.
  4. Business Conduct Standards and Eligible Contract Participants
    One of the lessons learned from the most recent financial crisis is that certain smaller and less sophisticated institutions need protections from abusive practices by their swaps intermediaries. There is a need for more stringent business conduct standards....

    Congress should consider revising the qualification standards for participation in the OTC derivatives markets. The standards for being an "eligible contract participant" ("ECP") are important under Treasury's proposal because only ECPs may trade derivatives over-the-counter. All other market participants must trade on exchanges, which provide better protections for less sophisticated participants. More specifically, Congress should consider raising the qualification standards for a governmental entity or political subdivision — such as a municipal government — to qualify as an ECP. Higher standards may also be appropriate for individuals, corporations and other entities.
  5. Protecting Customer and Counterparty Assets
    One key issue is how best to protect customer and counterparty assets in the event of insolvency....legislation should provide for an insolvency framework that protects, first and foremost, customers....a resolution regime should provide legal restrictions on how counterparty assets held by OTC derivatives dealers and other major market participants would be treated in the event of an insolvency, as well indicate the extent to which counterparties would have a prior claim on the other assets of the estate. Without legal certainty, the insolvency of an OTC derivatives dealer or other major OTC derivatives participant could result in further market disruptions and systemic risk.
  6. Ensuring that the "Identified Banking Products" Exception is Not Abused
    Treasury's proposal contains an exclusion from the regulatory scheme for OTC derivatives for products that are "identified banking products." Although this exclusion may make sense for banks that are regulated in the U.S., we believe that this exclusion could allow foreign banks (and their subsidiaries) that are not subject to oversight by any federal banking regulator, to offer OTC derivatives to U.S. persons in the guise of "bank products." I believe this exclusion should be revised to make clear that it is not available to foreign banks or their subsidiaries that are not subject to federal banking oversight.

Read her entire House testimony here.

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