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Born On the Warpath

By Robert Hunter

If there were a financial version of the Richter Scale, the near implosion of Long-Term Capital Management in September would have pushed the needle to a mountainous peak. Now, three months later, massive aftershocks are still being felt—especially in the nebulous world of derivatives regulation, where the plight of LTCM has rekindled the debate over the need to oversee the world's $30 trillion over-the-counter derivatives industry.

At the center of the debate, predictably, is Commodity Futures Trading Commission chairperson Brooksley Born, who for the last year has single-handedly championed the cause of reexamining the issue of OTC regulation. In May, the CFTC issued a concept release arguing for the need to reevaluate the 1993 swaps exemption to the Commodity Exchange Act, which stipulated that a swap is not a futures contract and therefore is not subject to CFTC regulation.

That drew the ire of many, both in the derivatives industry and in regulatory circles. In fact, SEC chairman Arthur Levitt, Federal Reserve chairman Alan Greenspan and U.S. Treasury secretary Robert Rubin issued an unprecedented joint statement attacking the release. A subsequent Congressional moratorium on CFTC action in OTC regulation until March 31, 1999—which finally passed as part of the omnibus budget bill in early October—seemed certain to put the issue on ice until next year.

But the LTCM debacle provided Born with the grist she needed to rejuvenate her campaign to reexamine OTC regulation, and she wasted no time in doing so. She appeared before Congress in hearings on the LTCM mess in September, and in October she addressed the Chicago-Kent College of Law Derivatives and Commodities Law Institute: “There is an immediate and pressing need to address possible regulatory protections in the OTC derivatives market,” she said. “The LTCM episode not only has demonstrated the potential risks posed by the OTC derivatives market for the domestic and global economy, but also has highlighted the importance of [having] safeguards in place for exchange-traded futures and options.”

“There is an immediate and pressing need to address possible regulatory protections in the OTC derivatives market.”
Brooksley Born

In a number of public speeches since September, Born has reiterated four main points that flow from the LTCM episode: that there is an alarming lack of transparency in the OTC markets; that the OTC market allows for excessive leverage; that there are insufficient “prudential controls” in place in firms operating in the OTC markets; and that there's a need for a coordinated international approach to OTC regulation. The problems of LTCM and other hedge funds, she has argued repeatedly, underscore the need for OTC market regulation.

Singling out hedge funds

Behind the scenes, Born is taking a different tack: using her jurisdiction to effect at least partial disclosure of hedge fund activities, which, she maintains, often remain shrouded in secrecy, to the detriment of investors. In early October, the CFTC issued a confidential “special call” to futures commission merchants to voluntarily disclose information about their hedge fund clients by October 19, including whether hedge fund clients had missed margin calls at any time since January. The request also reportedly asked for disclosure of hedge fund clients' OTC activities that might influence “a materially affiliated person” or companies that transact in the listed markets that the CFTC oversees.

Later in the month, however, amid vocal protests from the FCM community, the CFTC retreated a bit. Working with lawyers from the Futures Industry Association, the CFTC limited its request to disclosure only of hedge fund clients' futures and options activities, and moved the reporting date back to November 5. The CFTC retained its request for information on whether hedge funds had suffered significant losses or failed to meet margin and capital requirements.

Despite the noticeable retreat, however, many FCMs are furious. Some complain that disclosing such information could lead to a diminution of a client's reputation and hence to a retaliatory lawsuit. “We're being asked…to provide an analysis that could expose us to potential civil litigation down the road,” says Credit Suisse First Boston's Robert Paul. “We have to be sure customer confidences are maintained, and we have the reputation risk that we are not to be trusted.” Others worry that disclosure would drive clients abroad to more regulation-friendly countries such as the United Kingdom, which is experimenting with a unified financial regulatory scheme called the Financial Services Authority.

Some FCMs are even calling for outright abolition of the CFTC. The commission, says John Davidson, a managing director at Morgan Stanley, “ought to ride out into the sunset.” He believes it “has outlived its usefulness as a regulator and ought to be consolidated with the Securities and Exchange Commission.”

Such complaints come at a shaky time for the CFTC. Senator Richard Lugar (R-Ind.), chairman of the Senate Agriculture Committee, which oversees the CFTC, has moved up formal reauthorization hearings from next year to this month. The CFTC is a temporary body and must be reauthorized periodically. Lugar, staunchly opposed to any OTC regulation, is bothered by Born's recent acknowledgment that she may issue regulation soon after the moratorium ends next March if market conditions warrant such action. He has also bristled at reports that Born plans to lobby for permanent status for the CFTC next year.

“[The CFTC] has outlived its usefulness as a regulator and ought to be consolidated with the Securities and Exchange Commission.”
John Davidson
managing director, Morgan Stanley

As a result, this year's reauthorization hearings should be especially heated. “This committee is not going to be satisfied at this point with looking at one-line reauthorization,” says Lugar. “We are going to fundamentally look at what we're controlling, why we are controlling, who should be controlling and [whether we] should be controlling.”

While Lugar admits that the LTCM issue must be examined, he chafes at the notion of more regulation. “We really have to come to grips with the problems posed by the CFTC as well as these overall risk-taking problems. Investments need stimulus as opposed to dampening.”

One thing is certain: This will be a December to remember for the CFTC.