Two cooks spoil the broth

Two cooks spoil the broth

The financial reforms being considered by the US Congress seem fundamentally sound.

First, find out the size, shape and behavior of over-the-counter transactions by putting as many as possible on to visible trading venues. Second, establish a reliable system of collateralization for them, following the adage “In God we trust, the rest pay cash”.

Finally, provide the safety net of a central counterparty clearing mechanism that can rescue a deal even when the direct parties and their intermediaries have exhausted their resources.

But the reforms include two features that seem weird. First, the classification of credit default swaps (CDS) as securities. And second – despite having had a decade in which to learn better – Congress expects the Securities and Exchange Commission and the Commodity Futures Trading Commission to develop joint regulations (or at least, lookalike ones).

The oddity of treating CDS as securities is that they are structured quite differently.

It is true that they are options: you pay me a fee and I will pay you a principal amount if a financial instrument (quite likely a security) defaults.

But unlike the normal equity options that are regulated by the SEC, the value of CDS does not rise and fall in tandem with the price of the underlying security and they convey neither a right to buy nor a right to sell that security.

In fact, CDS have all the hallmarks of insurance policies, and are therefore simply event-linked options of the type that the CFTC normally regulates.

A CDS exists to encourage people to hedge against their risks – the focus of the CFTC’s activity – rather than to encourage people to contribute capital to the economy – the SEC’s mission.

Swap trap

More concerning is the bill’s desire that the SEC and CFTC coordinate their standards in some areas. Notably, they would have to cooperate on regulating security-based swaps (at the SEC) and all other swaps (at the CFTC).

Pious hopes that the two agencies will get along have informed legislation before. Back in 2000, Congress asked them to co-regulate futures on single corporate securities and on small stock indices. They would have no difficulty agreeing on terms, right?

In fairness, the two regulators did create rules to launch a basic equity futures trading program on both the futures and securities exchanges. And, in 2006, they widened it to include futures on debt securities as well.

But the fact that it took six years to make even that small leap was unsettling to many observers.

Other joint initiatives planned in 2000 remain today unused or in hopeless chaos. Here are two examples.

The legislation that set up co-regulation for security futures said the SEC and CFTC could authorize trading of options on those futures in late 2003. As of mid-2010, nothing has happened.

Nine year stalemate

The same statute recognized a need to address the treatment of security futures listed on overseas markets. The laws administered by both agencies were amended to call for the adoption of joint regulations on this subject.

The CFTC’s legislation took a step toward addressing this question by declaring that foreign-listed security futures could be traded by anyone located outside the US and by any individual or entity that could meet standards applicable to “eligible contract participants”.

That means US individuals whose total assets exceed $10m, or $5m if they are hedgers. For US entities, the hedging bar is lower, at $1m.

Alas, no similar change occurred in the SEC’s statutes. As a result, activity that was explicitly lawful under the CFTC regime remained silently banned in the SEC world, awaiting the adoption of joint regulations.

From 2000 until mid-2009, that conundrum remained. Then, having been ordered by the Congress in 2008 to do something by the end of June 2009, the SEC acted.

But not without showing its displeasure. First, it waited until the very last day of June 2009 to comply. Then, it unilaterally adopted an exemptive order, setting standards radically different from what the Congress had selected in 2000 for the CFTC’s statute.

In brief, the SEC limited US participation in foreign-listed security futures to “qualified institutional buyers”, a term that generally requires the possession of $100m of investments in unaffiliated issuers.

This is 10 times the CFTC threshold even for US speculators and as much as 100 times the CFTC requirement for hedging entities.

Which raises one last question about the efficacy of joint rulemaking. The clause added to the statutes of both the SEC and the CFTC in 2000 required joint rulemaking on foreign-listed security futures. The act did not give the SEC authority to act alone by setting its own standards, through an exemptive order or any other means. Is the SEC’s order valid?

Congress would do well in its current financial reform debate to heed this experience and to allow the SEC and the CFTC to fashion their own separate programs for the new authority they will soon be assuming.

Philip McBride Johnson is head of the derivatives regulatory practice at Skadden, Arps, Slate, Meagher and Flom in Washington and a past chairman of the CFTC.

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