Proposals For Regulatory Reform And Existing Regulation

The debate over the future of financial regulation continues, as Congress and other parties rush to sort out the root causes of the market crisis. In that context, SEC Chairman Schapiro testified before Congress last week, recounting current and planned ruling making initiatives by the agency. She has also promised rejuvenated enforcement. Critical to her testimony is a request for additional funding which, as discussed here, is sorely needed. The CFTC has also requested additional funding.

If the market crisis demonstrates anything however, it is that more is needed than just a few new rules and additional funding. There are clear and well known gaps in the current regulatory system, as SEC Commissioner Aguilar pointed out in a speech discussed here. At the same time it is critical that a careful evaluation be made of the laws and regulations on the books and their role in the events which shaped the current crisis.

One of the key areas of focus for new legislation and regulation is derivatives. Last week, a call for legislative reform in this area came from CFTC Chairman Gary Gensler. In testimony before the Senate Committee on Agriculture, he outlined a framework for regulating derivatives. The goal’s of Mr. Gensler’s proposal is to lower systemic risks, promote transparency and market integrity and protect the public from improper market practices. The framework he outlined would apply to all OTC derivative dealers and OTC derivative markets regardless of the type of derivative traded or marketed.

Under the proposal, regulation would be extended to cover all derivatives dealers. Citing AIG as an example of the impact of unregulated derivatives, Mr. Gensler told the Senators that “by fully regulating the institutions that trade or hold themselves out to the public as derivative dealers, we can oversee and regulate the entire derivatives market.” As part of this regulation, which would require additional legislative authority from Congress, there should be capital requirements for all derivatives. In addition, Mr. Gensler called for business conduct and transparency requirements which would include standards for the timely and accurate confirmation, processing, netting, documentation and valuation of all transactions as well as standardized recordkeeping and reporting requirements.

To promote safety and transparency, derivatives transactions should be moved into a central clearing house and would be required to be cleared through regulated central clearing houses under this proposal. This would require product standardization. The exchanges and clearing houses would be regulated by the CFTC and the SEC according to their respective authority. In Mr. Gensler’s view one of the lessons of “too big to fail” is the interconnectedness of various players in these markets. Trading derivatives on exchanges and clearing through central clearing houses would reduce this difficulty, thereby mitigating risk while increasing transparency. Risk could be further reduced by using position limits.

For those derivatives which are customized and could not be exchange traded, Mr. Gensler suggests that risk can be reduced and transparency increased if the CFTC is given authority to require record keeping and reporting, as well as to impose margin requirements and to prevent fraud. In this regard he would require a full audit trail that would be available to the CFTC and other Federal regulators. Mr. Gensler told the Senate panel that his framework would provide for comprehensive regulation of the derivatives markets.

Mr. Gensler’s proposals build on recent steps taken by the SEC, CFTC and the Treasury Department to improve the transparency in the OTC derivatives market. While each has only limited authority in this area, plans are proceeding for central counterparties for the clearing of credit default swaps by LCH. Clearnet Ltd., ICE US Trust LLC, and Chicago Mercantile Exchange Inc. This of course does not address the huge customized market which apparently is lobbying to remain unregulated. Gretchen Morgenson and Don Van Natta Jr., In Crisis, Banks Dig In For Fight Against Rules, New York Times at 1 (June 1, 2009) (available here, registration required).

Whether Chairman Gensler’s proposed framework will resolve a large part of the interconnectedness and too big to fail question is debatable. At the same time, it is clear that there are significant regulatory gaps in the authority of the SEC and CFTC in this area by congressional design.

Equally clear is the fact that OTC derivatives have had a significant impact on public companies such as AIG, Lehman Brothers and others and are central in the “too big to fail” debate. Those companies however, as well as many other players in the derivatives markets, are subject to disclosure obligations which are suppose to inform shareholders and the markets about the financial condition of the company. For example, the MD&A section of quarterly and annual reports is supposed to put the reader in the chair of the corporate executive, effectively putting the reader’s hand on the pulse of the company cash flow and future liquidity. Yet the almost collapse of AIG for lack of cash (but for a federal bail out) and the demise of Lehman, again for lack of cash (no bail out here), came as sudden huge shocks to the markets and investors. Clearly the markets did not know – apparently nobody outside the companies had their hand on the pulse of the cash flow as it trickled down to nothing. This is not a question of regulating derivatives. Rather, it is a disclosure of financial condition issue. Where was the disclosure?

All of this is to say that as the form and shape of regulatory reform is debated it might be well to revisit the current regulations and find out what happened and why before all the solutions are crafted and finalized. This is not to say that new regulation is not necessary. Only that a good starting point is to look at what is on the books already.