SEC chief stakes claim to regulate credit default swaps, other security derivatives

Exclusive reporting for FinReg21 by Darrell Delamaide

SEC chairman Mary Schapiro moved to close the deal on getting a big chunk of over-the-counter derivatives regulation for her agency.

In testimony before a Senate Banking subcommittee, Schapiro argued that all securities-related derivatives – including credit default swaps – should be regulated by the SEC as part of its statutory mission to regulate securities.

The reason: Trading in securities-related derivatives affects trading in the underlying securities.

“Securities-related OTC derivatives can be used to establish either a synthetic ‘long’ exposure to an underlying security or group of securities, or a synthetic ‘short’ exposure to an underlying security or group of securities,” Schapiro told the panel.

In this way, she added, traders can replicate the economics of a purchase or sale of securities without actually purchasing or selling the securities.

Credit default swaps, for example, can be used as synthetic substitutes for the debt securities of a company. As a result, Schapiro said, the SEC has been unable to watch out for trading abuses, such as whether purchasers of CDS protection on a company’s debt have sold the stock short as a trading strategy, thus linking activities in the CDS market to the cash equity market. 

“The direct link between securities-related OTC derivatives and securities is such that SEC regulation of the former is essential to the effectiveness of the SEC's statutory mission with respect to the securities markets,” Schapiro concluded.

The change to enable SEC regulation of these derivatives, Schapiro suggested, can be done with the stroke of a pen. “This result can be achieved simply by clarifying the definition of ‘security’ to expressly include securities-related OTC derivatives, and removing the current express exclusion of swaps from that definition,” she said in her prepared testimony. BREAK

Schapiro only wants to supervise the securities-related OTC derivatives. Primary responsibility for all other OTC derivatives – including those related to interest rates, foreign exchange, and commodities, which account for the bulk of derivatives – would rest with the CFTC.

Because securities-related derivatives can fulfill the same economic function as actual ownership of the stocks or bonds, some market participants have been able to create positions of virtual ownership that enable them to evade reporting requirements on accumulation of positions in a given company. BREAK

So the SEC, Schapiro said, is looking at whether it should interpret reporting under the Exchange Act as applying to security-based OTC derivatives – so that owning or trading in the derivatives would be considered ownership of and transactions in the underlying equity security.

In the same vein, the agency is evaluating whether persons using equity derivatives, such as an equity swap, should be subject to reporting beneficial ownership under the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

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Posted : Monday 22 June 2009 22:21 | Managing Editor

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