SEC, CFTC seek 'unimpeded' power over derivatives

"Unimpeded" oversight of the $592 trillion over-the-counter derivatives market should be shared between the Securities and Exchange Commission and Commodity Futures Trading Commission, the heads of those agencies said.

Primary responsibility for derivatives tied to securities, including credit-default swaps, should go to the SEC, agency Chairman Mary Schapiro told a Senate subcommittee in Washington today. Other derivatives, including those related to interest rates and commodities, should be regulated by the CFTC, Chairman Gary Gensler said. Both advocated a dual regulatory structure.

"The CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses," Gensler said.

Schapiro and Gensler are mainly seeking authority to subject derivatives dealers to capital, margin and disclosure requirements, as well as position limits. President Barack Obama and Congress are trying to sort out how best to regulate an industry that his administration has said was a "major source of contagion" in the global financial crisis.

"The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight," Gensler said in his testimony to the Senate Banking Subcommittee on Securities, Insurance and Investment.

'Emerging Consensus'

Congress may pass new derivatives laws with Obama's broader regulatory overhaul sometime this year, after lawmakers complete work on health care and other priorities, said Senator Jack Reed, a Rhode Island Democrat and chairman of the subcommittee.

"I was pleased that there was emerging consensus," Reed said of the financial regulators, adding "the details, they will have to work out."

Schapiro said the SEC is considering whether disclosure rules for stocks should apply to "security-based" derivatives that don't trade on exchanges. The agency also is weighing whether an equity swap tied to a company's performance should be treated the same as holding the shares, she said.

"Similar products and activities should be subject to similar regulations and oversight," Schapiro said. "The interchangeability of securities and securities-related" derivatives "means that they are driven by the same economic forces."

Capital, Margins

Gensler focused his testimony more on capital and margin requirements, saying they would prevent derivatives users like American International Group Inc. from amassing "large or highly leveraged risks outside the oversight of prudential safeguards of regulators." AIG was brought to the brink of bankruptcy and needed $182.5 billion in taxpayer aid because of credit-default swap trades on mortgage-linked securities.

"Credit-default swaps, given their unique nature, which have some attributes of insurance, some attributes of a security, some attributes of a derivative, are going to take a particular focus," Gensler told reporters after the hearing. "Our approach that we've recommended is to bring the dealers for these products, including credit-default swaps, under regulation."

Some lawmakers, including Senate Agriculture Committee Chairman Tom Harkin, want a more aggressive approach than what the Obama administration is backing. Harkin, an Iowa Democrat, is pushing legislation that would require all over-the-counter derivatives trades be cleared through a regulated exchange. Such an arrangement would subject the contracts to margin and collateral requirements.

'Wake Up Call'

"Until recently, the prevailing presumption was that market discipline alone largely protected us from any potential risk we faced from OTC derivatives," Reed said. Reed called the near-failure of AIG a "wake up call."

Having clearinghouses back all over-the-counter trades may not be feasible and might not reduce risk, Patricia White, associate director of the Federal Reserve's research and statistics division, told the subcommittee.

If clearinghouses "have difficulty designing margin and default procedures for such products, they will not be able to effectively manage their own counterparty credit risk to clearing members," White said.

Gensler said the Obama administration's proposal would see that all "standardized" contracts trade through an exchange or a transparent trading system similar to the Trade Reporting and Compliance Engine, or TRACE, system used by bond dealers.

Banning Credit Derivatives

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Credit- default swaps were created initially as a way for banks to hedge their risk from loans. They became a popular vehicle for hedge funds, insurance companies and other asset managers to speculate on the quality of debt or on the creditworthiness of companies because they were often easier and cheaper to trade than bonds.

Senator Jim Bunning, a Kentucky Republican, said some derivatives, such as credit-default swaps, are "just plain gambling."

The economy's longest recession since the 1930s was triggered when credit markets froze in August 2007 after banks such as Lehman Brothers Holdings Inc. found they couldn't determine the value of trades linked to mortgage bonds.

Trading in credit-default swaps should be banned, Christopher Whalen, managing director of Institutional Risk Analytics in Hawthorne, California, said in prepared testimony for today's Senate hearing. Regulators are too cozy with the banks in the market to be counted on to make changes, he said.

Swinging the Pendulum

Senator Mike Crapo, a Idaho Republican, cautioned lawmakers against "letting the pendulum swing too far to the other side where it would cause damage to the economy" by constricting companies like Cargill Inc. and Caterpillar Inc. from using derivatives to hedge interest rate, currency and other risks.

The Electric Power Supply Association, a Washington-based trade group representing companies including Exelon Corp. and Constellation Energy Group Inc., said forcing energy derivatives onto exchanges would drive up the costs of hedging and reduce market liquidity. Regulators could instead impose reporting requirements, akin to the quarterly reports companies must submit to the Federal Energy Regulatory Commission, the association said in a report today.

It's a second chance for Congress, whose 2000 exemption of derivatives from regulation helped the market swell to $684 trillion by June 30, 2008, from about $100 trillion in 2000, according to Bank for International Settlements data. Credit- default swaps outstanding ballooned almost 100-fold within seven years to top $62 trillion by the end of 2007, according to estimates from the New York-based International Swaps & Derivatives Association.