Brooksley Born and the Regulation of OTC Derivatives

An important agenda item for the new Administration is reform of financial market regulation. As of now, it is not clear what the Administration will propose. There is a general feeling that the current regulatory system has failed, especially the bank regulators and the SEC.

The CFTC has for the most part remained in the background. It has over the past year received some attention because of increases in energy prices, which some would blame, with little evidence or logic, on the activity of speculators in futures markets. Now that energy prices have come down, that issue has receded. The current financial crisis has not shined the spotlight on the CFTC, for which I am sure the people who work there are grateful.

Currently, there is a tendency to lionize former CFTC Chairperson Brooksley Born for her stand on the regulation of OTC derivatives in face of the opposition of Secretary Rubin and Chairman Greenspan. The story is a little more complicated than that. Here is a brief account of what I remember from that time.

It is true that the CFTC under Chairperson Brooksley Born had pushed for greater regulation of OTC derivatives. The CFTC had in mind clawing back 1993 exemptions for swaps it had issued after being granted the authority by the Futures Trading Practices Act of 1992.

Brooksley Born failed in this effort. One of the reasons for her failure is that she stubbornly maintained that OTC derivatives were subject to the Commodity Exchange Act (“CEA”), an argument, which, for technical reasons, put into question the legality of certain outstanding derivatives, such as total return swaps based on equity securities. It also seemed by her insensitivity to this issue that she was motivated too much by turf considerations. That guaranteed that others, especially the bank regulators, would oppose the CFTC on this.

Secretary Rubin was, in fact, concerned about OTC derivatives because he felt that they might be increasing systemic risk. (It should be kept in mind that the Treasury had little turf to be concerned about with regard to this issue, except that of the Office of the Comptroller of the Currency, which is fairly independent from the Departmental Offices and, consequently, is often left to fend for itself.) Because Rubin had sympathy with Born’s policy concerns, though not her legal arguments or apparent turf grabbing, he proposed that the President’s Working Group on Financial Markets ask a series of questions to the public about OTC derivatives, similar to the questions the CFTC had prepared for a concept release on the subject. Born refused, and despite pleas from the other members of the PWG, went ahead with the concept release in May 1998.

Her intransigence on this subject drove Rubin into Chairman Greenspan’s corner, much to the relief of the major OTC derivatives dealers who were not unaware that the Secretary was not entirely comfortable with their business. There is a chance that, if Born had approached Rubin and SEC chairman Arthur Levitt with her policy concerns rather than with her legal arguments, she might have been able to get their support for some greater oversight of the derivatives industry. It is possible that some of the discussion would have focused on how to do it and who should do it, though Greenspan and others would have continued to argue that any government interference in the form of regulation of this market would be harmful. In any case, that would have been a healthier and more productive debate than the endless, and ultimately boring, legal debate over whether swaps are futures.

Both Brooksley Born and Secretary Rubin left their government posts in mid-1999. They were replaced by William Rainer at the CFTC and Larry Summers at Treasury. The change in personnel made possible for the PWG to make unified recommendations on the CEA in a November 1999 report, Over-the-Counter Derivatives Markets and the Commodity Exchange Act. This paved the way to the eventual enactment of the Commodity Futures Modernization Act of 2000 at the end of the Clinton Administration.

The CFTC under Rainer gave up any ambitions to regulate the OTC derivatives market and accepted lessened regulatory authority over the futures exchanges. But now with talk of both merger of the CFTC with the SEC and the desire, though hardly universal, for greater regulatory oversight of the OTC derivatives market, the issues of how to rationalize regulation in this area will come to the fore. The issues are both substantively and politically very difficult.