MARKET REFORM LEGISLATION AND THE DERIVATIVES MARKET
Market reform legislation some call the most sweeping since President Franklin Roosevelt signed the bills which brought regulation to the securities and commodities markets is on the horizon. Each chamber of Congress has passed a bill. There are substantial similarities and significant differences between the bills which should go to conference shortly. While some critics argue that the mammoth bills – each is over one thousand pages – do not go nearly far enough, there is no doubt that if enacted they will bring significant changes. Few doubt that shortly the President will have a final bill to sign.
CFTC Chairman Gary Gensler is on the stump as Congress prepares to finalize the legislation, arguing for a strong final product based on key provisions of each bill. Mr. Gensler argues that the provisions each bill which would bring transparency to the over-the-counter derivatives market are critical to dealing with the root causes of the 2008 market crisis. Each bill has robust record keeping and reporting requirements for all derivative transactions. Each would require on-exchange transactions and bilateral transactions that regulators could police. Each bill would also require that all standardized products be traded on regulated exchanges or similar vehicles. This will bring transparency for these transactions to the public, which in turn, will also narrow the pricing spreads and ultimately reduce risk for the system. An overall better pricing mechanism helps avoid the difficulties of the 2008 market crisis when assets were labeled “toxic” that could not be priced.
Mr. Gensler also notes that real time post-trade reporting of transactions is critical to a transparent marketplace. The Senate bill includes this requirement which should be included in the final bill.
Centralized clearing is also a critical part of any regulatory reform in these markets. Standardized derivatives should be cleared through central clearinghouses which act as middlemen between the two parties. In that role they guarantee the obligations of both parties and thereby avoiding incidents such as the taxpayer bail out of AIG whose unregulated $2 billion derivatives portfolio nearly brought down the financial system. In this regard the goal of reform should be to move as many standard over-the-counter derivatives into central clearing as possible. Accordingly, the conferees should resist exemptions and narrowly draw the provisions which exclude bank transactions with their end user customers.
Citing data from the Bank for International Settlements, Mr. Gensler noted that derivative transactions between dealers and other financial entities such as hedge funds or insurance companies make up the largest number of deals. The Senate bill requires that standard derivatives of financial entities be brought to clearing houses. This contrasts with the house bill, which has a liberal exemption for entities using derivatives to hedge commercial, balance sheet or operational risk. That exemption could leave a large class of transactions out of the clearing requirement Mr. Gensler cautioned. As long as entities remain interconnected through there derivatives, the failure of one could topple another. Accordingly, every exemption creates a link “a link in the chain between a dealer’s failure and a taxpayer bailout.” The conferees should thus ensure that exemptions do not allow interconnectedness in the system.
The clearinghouses also must be effectively regulated to avoid conflicts. Likewise, they should be open to both dealers and non-dealers and have open access taking on trades from any regulated exchange or swap execution facility. Those clearing houses should also have open membership.
If there is to be true financial reform and protection for the public, it is critical that financial reform come to the derivatives market. Mr. Gensler concluded his remarks by noting that any bill which does not reform the derivatives market is incomplete. Remarks of Chairman Gary Gensler, Sandler O’Neill Global Exchange and Brokerage Conference, New York, N.Y. (June 3, 2010).