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The OTC Wars

The CFTC turns up the heat on the swaps markets, igniting a new round of Brooksley-bashing.

By Robert Hunter

When the Securities and Exchange Commis-sion unveiled last December its “broker-dealer light” proposal, designed to encourage dealers to transact over-the-counter deals through their U.S. offices rather than their European units to repatriate what it viewed as needlessly lost business, the Commodity Futures Trading Commission plotted a course of action. The CFTC considered the SEC’s move to be a monumental encroachment on its turf, since only a tiny minority of OTC deals involve securities-based swaps—statutorily under the purview of the SEC—while the remainder of the derivatives business has traditionally fallen under the regulatory umbrella of the CFTC.

In February, CFTC chairwoman Brooksley Born issued a retaliatory salvo in what has become a full-fledged turf war. She announced that the CFTC was planning to revisit its 1993 swaps exemption, and fired off an angry letter to SEC chairman Arthur Levitt denouncing broker-dealer light for taking the 1.4 percent of the $28 million OTC market under its control and setting up a regulatory scheme for the entire industry. The nation’s dealers, who had been operating quite happily under the 1993 CFTC ruling that “a swap is not a future,” and therefore did not have to be traded on an exchange and regulated by the CFTC, quickly united against Born.

Then on May 7, the CFTC put its concerns in writing, in a 62-page concept release ostensibly designed to spark dialogue on the 1993 swaps exemption. The subtext, however, was clear: the CFTC may have giveth the exemption, but it can taketh away as well. “The substantial changes in the OTC derivatives market over the past few years require the commission to review its regulations,” the release reads. It then identifies a number of areas in which “potential changes” to its exemptions are possible, including “eligible transactions, eligible participants, clearing, transaction execution facilities, registration, capital, internal controls, sales practices, record keeping and reporting.”

“I don’t think there’s any indication whatsoever that this is a precursor to making swaps illegal.”
Brooksley Born

Despite such an apparently sweeping mission, the release stressed that “The commission urges commenters [sic] to analyze the benefits and burdens of any potential regulatory modifications in light of current market realities. The commission has no preconceived result in mind…[and] is open both to evidence in support of easing current restrictions and evidence indicating a need for additional safeguards.” Indeed, Born told the Wall Street Journal that she would drop the issue completely “if that’s what our analysis indicates is appropriate.” But such platitudes rang hollow to industry insiders, who noted that concept releases are often followed by significant regulatory changes. Many believe that sales practices and hybrid transactions will be the first areas to fall under CFTC regulation, shortly after the comment period on the concept release ends.

Such a possibility does not sit well with other regulators. Despite assurances in the release that current contracts will not be impacted by any future regulatory actions, the U.S. Treasury, the Federal Reserve and the SEC fear the destabilizing effects that regulation could wreak. The three groups are so strongly opposed to regulation, in fact, that they issued an unprecedented joint statement denouncing the concept release the day it was issued.

“We have grave concerns about this action and its possible consequences,” the statement reads. “We seriously question the scope of the CFTC’s jurisdiction in this area, and we are very concerned about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives. The concept release raises important public policy issues that should be dealt with by the entire regulatory community working with congress, and we are prepared to pursue, as appropriate, legislation that would provide greater certainty concerning the legal status of OTC derivatives.”

Born brushed off the attack. “We’re only asking questions,” she said. “I don’t think that’s very explosive. I don’t think there’s any indication whatsoever that this is a precursor to making swaps illegal.”

But making swaps illegal down the road isn’t the main concern of the SEC, Treasury and Fed—or most Wall Street dealers. They fear that Born’s contention that swaps share many characteristics with futures could be invoked right now by a swap counterparty who has lost a bundle on a deal. Since Born has introduced the possibility that swaps can be considered futures, and since futures by law must be traded on exchanges, swaps could thus be considered illegal futures, and burned counterparties could refuse to pay out on unsuccessful deals.

Wall Street has voiced other concerns as well, most notably that increased regulation of OTC markets in the United States could send even more business overseas, and that bad regulations that curtail market growth and liquidity are worse than no regulations at all. The fact that one of the five CFTC commissioners, Barbara Holum, issued a dissenting opinion underscores the contentiousness of the issue. “The release goes beyond the scope of regulatory review by exploring regulatory areas that may be inapplicable to an OTC market,” she wrote.

“The release goes beyond the scope of regulatory review by exploring regulatory areas that may be inapplicable to an OTC market.”
Barbara Holum
commissioner, CFTC

But not everyone in the derivatives business has aligned with the critics. The nation’s futures exchanges, for one, have exalted the concept release. “Exchanges are subject to multiple levels of scrutiny,” said Dale Carlson, a spokesman for the Pacific Stock Exchange, “and to the extent that OTC players don’t have to bear those costs, in some sense they have an unfair advantage.” Others note that a degree of regulation, such as mandatory disclosure of information about risk levels and other relevant data, may attract participants afraid of the negative aura that still surrounds the derivatives business after the disasters of the last few years.

One thing is certain: the CFTC should brace itself for a flurry of comments in the next month. The ubiquitous Sen. Richard Lugar (R-Ind.), chairman of the Senate Agriculture, Nutrition and Forestry Committee, which oversees the futures business, has already spoken out against any regulatory encroachment on the OTC market. If the CFTC chooses to pursue the matter, a wave of Congressional hearings could be in the offing.

For a copy of the concept release, see www.cftc.gov.

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