Analysis: New CFTC chief gets religion, presents plan to rein in OTC derivatives

Exclusive analysis for FinReg21 by Darrell Delamaide 

What was most amazing about the measures to regulate over-the-counter derivatives laid out this week by the newly confirmed chairman of the Commodity Futures Trading Commission, Gary Gensler, was that these things aren’t already being done. 

It was basic stuff long seen as necessary for the healthy functioning of financial markets – things like tracking trades and prices, clearing, registering market participants, setting prudential requirements for capital and position limits. 

Of course, the CFTC, in the person of then-chairman Brooksley Born, did in fact try to get these regulatory controls in place back in the Clinton administration. But she was overruled by Treasury heavyweights Robert Rubin and Larry Summers, and even Gensler himself. 

When Sen. Michael Bennet (D-Colo.) asked the new chairman, who was sworn in eight days earlier, if the build up of leverage via derivatives over the past eight years was a result of the Commodity Futures Modernization Act of 2000, Gensler sidestepped the obvious answer by saying OTC derivatives were not regulated prior to the CFMA, either. 

But Gensler, who in the meantime earned his regulatory bona fides by working on the Sarbanes-Oxley Act, seems to have gotten religion in this regard as he asked for authority to regulate all derivatives traders regardless of what type of institution they are affiliated with and to regulate the entire infrastructure for trading derivatives. 

His vision of “comprehensive” framework for regulating OTC derivatives, presented at hearing of the Senate Agriculture Committee, fleshed out the pledge made by Treasury Secretary Timothy Geithner to rein in a runaway market that many blame for helping to cause the financial crisis. If translated into law, it promises to be one of the most immediate and concrete reforms to come out of the crisis. 

“A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed,” Gensler said in his sweeping definition of what the new regulation would include. “It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.” 

The twin regulation of both dealers and trading infrastructure was the key to keeping surveillance of the entire market. It also addressed the criticism of Geithner’s plan that by exempting customized swaps from the requirement to go through a trading platform or clearing house he was creating a big loophole that banks would exploit. 

These tailored derivatives, which may not be suitable for exchange trading because of limited market demand, would still be regulated by CFTC surveillance of the dealers and the capital requirements and aggregated position limits that go with that, Gensler said. 

He also listed several criteria the agency would look at to make sure that dealers would not try to label what is really a standardized product as a customized product to keep from having to trade it through a clearing house. 

Derivatives traders are resisting the changes because transparency in price discovery that is gained through exchange trading and clearing can cut into the profitability of these transactions. Dealers have more leeway in setting prices when the buy-side has to solicit prices from individual dealers and does not have the same information about where the market is. 

The industry did make an effort earlier in the week to document its goodwill in accepting that derivatives trading will need more structure. In a letter to the Federal Reserve Bank of New York, the major dealers outlined measures they had agreed to help reduce the systemic risk posed by derivatives. 

These included data repositories for non-cleared transactions to ensure appropriate transparency and to assist regulators with their oversight; clearing for OTC standardized derivative products; enabling customer access to clearing through either direct access as a clearing member or via indirect access; and delivering robust collateral and margining processes, including portfolio reconciliations, metrics on position and market value breaks, and improved dispute resolution mechanics. 

The industry would like for it to stop there, but, given that Agriculture Committee chairman Tom Harkin (D-Iowa) has introduced legislation requiring all contracts to be traded on an exchange, the type of compromise offered by the administration that exempts customized contracts is probably the best they can hope for. 

Following Gensler’s testimony Thursday, the Securities Industry and Financial Markets Association reiterated its desire to help reduce risk in OTC derivatives, while warning that forcing all of them to trade on an exchange “would eliminate customized contracts, exposing American business to higher costs, greater risks or both.” 

Gensler seemed visibly happy to finally be installed in his new post after his nomination was held up for months in the Senate by objections from Vermont independent Bernie Sanders and another senator. He meticulously thanked each of the senators on the panel for supporting his nomination. 

Only one week in the job, Gensler was ready to defend his agency’s turf. When asked about suggestions emanating from the administration that the CFTC be merged into the SEC, Gensler said he didn’t think anyone would suggest that one of the causes of the financial crisis was that the two agencies were not unified. 

“I don’t think a merger would accomplish much for the American public right now,” he told the lawmakers. If someone presented a compelling argument for merger, he added, it might be worth discussing, but a merger for merger’s sake does not seem to be particularly helpful. 

By contrast, SEC officials have publicly urged a merger. Chairman Mary Schapiro said in congressional testimony on Tuesday that such a move would be “logical.” The very next day, SEC commissioner Luis Aguilar also spoke in favor of a merger. “By combining these entities, you create a financial regulatory structure that truly has oversight over the entire capital market,”