Bringing transparency and accountability to derivatives

The Banking Committee’s summary of the bill sets out the rationale for tightening derivatives regulation. It highlights how the OTC market “has exploded – from $91tr in 1998 to $592tr in 2008”, and how during the financial crisis, “concerns about the ability of companies to make good on these contracts and the lack of transparency about what risks existed caused credit markets to freeze”.

“Over-the-counter derivatives are supposed to be contracts that protect businesses from risks, but they became a way for traders to make enormous bets with no regulatory oversight or rules and therefore exacerbated risks,” the summary says. “Because the derivatives market was considered too big and too interconnected to fail, taxpayers had to foot the bill for Wall Street’s bad bets. Those bad bets linked thousands of traders, creating a web in which one default threatened to produce a chain of corporate and economic failures worldwide. These interconnected trades, coupled with the lack of transparency about who held what, made unwinding the ‘too big to fail’ institutions more costly to taxpayers.”

The bill’s measures include:

· Closing regulatory gaps The bill authorises the SEC and CFTC to regulate over-the-counter OTC derivatives so that irresponsible practices and excessive risk-taking cannot escape regulatory oversight. It uses the administration’s outline for a joint rulemaking process with the Financial Stability Oversight Council stepping in if the two agencies cannot agree.

· Central clearing and exchange trading Central clearing and exchange trading would be required for derivatives that can be cleared. Both regulators and clearing houses would have a role in determining which contracts should be cleared. The SEC and CFTC must pre-approve contracts before clearing houses can clear them.

· Safeguards for uncleared trades Firms would have to post margin for uncleared trades to offset the greater risk they pose to the financial system and to encourage more trading to take place in transparent, regulated markets. Swap dealers and major swap participants will be subject to capital requirements.

· Market transparency: All trades must be reported to clearing houses or swap repositories to improve market transparency and help regulators monitor and respond to risks.

Systemic risks

An important proposal is to create a nine member Financial Stability Oversight Council, chaired by the Treasury secretary, and including the heads of the US Securities and Exchange Commission and Commodity Futures Trading Commission.

This will be able to recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, especially for those that pose systemic risk.

With a two-thirds majority, the council will be authorised to require that a non-bank financial company of systemic importance be regulated by the Federal Reserve – or to break up a large company if it posed “a grave threat to the financial stability of the United States”.

A new Office of Financial Research at the Treasury would support the council’s work by collecting financial data and conducting economic analysis. In particular, it will strive to make emerging risks to the economy transparent.

The council would also identify systemically important clearing, payments, and settlements systems to be regulated by the Federal Reserve.

Pay and corporate governance

The bill addresses weaknesses in US corporate governance and perceptions that executive pay schemes have contributed to the financial crisis. “In this country, you are supposed to be rewarded for hard work,” says the Banking Committee’s summary of the bill. “But Wall Street has developed an out of control system of out of this world bonuses that rewards short term profits over the long term health and security of their firms.”

Shareholders would gain the right to a non-binding vote on executive pay and more powers to nominate and vote on directors. Listed companies will have to publish charts comparing their executive pay with share price performance over five years.

Beefing up the SEC and investor protection

The bill tackles the SEC’s failures in the financial crisis, such as not stopping the Bernard Madoff fraud.

Whistleblowers will be encouraged with rewards of up to 30% of funds recovered. There will be an annual assessment of the SEC’s internal supervisory controls and a Government Accountability Office study of its management.

The bill would require a study on whether brokers who give investment advice should be held to the same fiduciary standard as investment advisers – that they act in their clients’ best interest.

It would create an Investment Advisory Committee, a committee of investors to advise the SEC on its regulatory priorities and practices, as well as an Office of Investor Advocate in the SEC, to identify areas where investors have significant problems dealing with the SEC and provide them assistance.

The self-funded SEC will also no longer be subject to the annual Congress appropriations process.

Hedge funds

The bill addresses the lack of information available to regulators about the huge hedge fund sector.

Hedge funds that manage over $100m will be required to register with the SEC as investment advisers and provide information about their trades and portfolios necessary to assess systemic risk and protect investors.

The bill would raise the assets threshold for federal regulation of investment advisers from $25m to $100m, increasing by 28% the number of advisers supervised at the state level.

“States have proven to be strong regulators in this area,” the bill’s sponsors believe, “and subjecting more entities to state supervision will allow the SEC to focus its resources on newly registered hedge funds.”

Ending too big to fail bailouts

Extensive rules are planned that are designed to ensure taxpayers do not have to bail out financial firms and to address the moral hazard problem that the bailouts of the past two years have created.

Besides discouraging “excessive growth and complexity” by setting progressive capital and liquidity rules that are tougher for bigger and more complex companies, the Financial Stability Oversight Council will be charged to make a study on the so-called Volcker Rule, proposed by former Fed chairman Paul Volcker.

This would require regulators to ban banks from proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit banks’ relationships with hedge funds and private equity funds. The Council would develop such regulations after consideration.

Big financial firms will also have to submit “funeral plans” – known in the UK as “living wills” – showing regulators how they could be easily shut down if they failed. Penalty costs for failing to produce a credible plan would create incentives for firms to clean up structures that could not be unwound easily.

The bill would create an orderly liquidation mechanism for the Federal Deposit Insurance Corporation to unwind failing systemically significant financial companies. Shareholders and unsecured creditors would bear the losses and management would be removed.

The Treasury, FDIC and Federal Reserve would all have to agree to put a company into the orderly liquidation process. A panel of three bankruptcy judges would have to convene and agree within 24 hours that a company was insolvent.

A levy on the largest financial firms, over time, would harvest $50bn to fill an upfront fund to be used if needed for any liquidation. The intention is that the financial industry, not taxpayers, would take a hit for liquidating large, interconnected financial companies.

The FDIC would be allowed to borrow from the Treasury only for working capital that it expected to be repaid from the assets of the company being liquidated. The government would be first in line for repayment.

The bill updates the Federal Reserve’s 13(3) emergency lending authority to prohibit emergency lending to an individual entity. The Treasury secretary must approve any lending programme, and such programmes must be broad and not aid a failing financial company. Collateral must be sufficient to protect taxpayers from losses.

Most large financial companies are expected to be resolved through the bankruptcy process.

To prevent bank runs, the FDIC can guarantee the debt of solvent insured banks, but only if top officials right up to the President agree.

Improving bank regulation

The bill aims to streamline the present system of four banking regulators, to reduce arbitrage and improve consistency and accountability. Clear lines of responsibility will be established.

The FDIC will regulate state banks and thrifts of all sizes and holding companies of state banks and thrifts with assets below $50bn.

The Office of the Comptroller of the Currency will regulate national banks and federal thrifts of all sizes and the holding companies of national banks and federal thrifts with assets below $50bn. The Office of Thrift Supervision is eliminated and there will be no new charters for federal thrifts.

The Federal Reserve will regulate bank and thrift holding companies with assets of over $50bn, drawing on its capital market experience. As a consolidated supervisor, the Federal Reserve is intended to see risks whether they lie in the bank holding company or its subsidiaries. It will be responsible for finding risk throughout the system. The vice-chair of the Federal Reserve will be responsible for supervision and will report semi-annually to Congress.

Jon Hay +44 207 779 8372 jhay@fow.com