During her tenure as CFTC chair, Brooksley Born was tenacious in making the argument that OTC derivatives came under the CFTC’s jurisdiction. The argument she made is plausible though it has never been fully tested in court. It is not clear how the courts would have handled this issue.
Simply put, the CFTC has exclusive jurisdiction over commodity futures and options contracts. The Commodity Exchange Act has a very broad definition of the word “commodity” which means that intangibles, such as interest rates, are commodities for the purposes of the CEA (though, amusingly, there is a specific exclusion of onions from the definition). There is, however, no definition in the CEA of a futures contract.
The swap market developed in the 1980s with this legal uncertainty. If some swaps were commodity options, then they fell under the jurisdiction of the CFTC and were not legally permissible unless the CFTC had granted an exemption from the exchange trading requirement of the CEA. More seriously, if other swaps were deemed to be futures contracts, then they were illegal and unenforceable contracts. The CFTC did not then have the authority to grant an exemption from the exchange trading requirement for futures contracts.
Because of these concerns, the CEA had been amended, and by the time the PWG was looking at this issue before the CFTC issued its concept release on OTC derivatives, the CFTC had been given authority to exempt many OTC derivatives from most of the provisions of the CEA. The CFTC under Wendy Gramm (wife of the Senator) had granted broad exemptions from the CEA. The important point here is that this made it clear that the contracts were legal and enforceable, that is, “legal certainty.” The CFTC in granting the exemptions did not make a determination that the contracts fell under its jurisdiction; what it was in effect saying was that if these contracts were subject to the CEA, they were nevertheless legal and enforceable contracts.
There was an exception to the broad exemptive authority that the CFTC had been given and that the CFTC had used. The CFTC could not grant exemptions from the provisions of the CEA implementing the Shad-Johnson Accord. This meant that OTC contracts that were futures contracts on equity and other non-exempt securities were illegal and the CFTC did not have the authority to make them legal by granting exemptions.
The concern was that if the CFTC claimed that it had authority over OTC derivatives then a subset of these contracts was in its view illegal. For example, the legality of total return swaps would have been put into question.
Defenders of Brooksley Born, who are many now that problems with credit default swaps are generally assumed at least to have worsened the financial crisis (whether or not they were a cause in the first instance), point out that when the CFTC issued its concept release there was no adverse market reaction. They also criticized Rubin, Levitt, and Greenspan for promptly putting out a statement that they disagreed with the CFTC’s action and for getting Congress to enact a statutory provision forbidding the CFTC from doing anything more in this area.
These criticisms miss the point, whether or not one thinks OTC derivatives should have been subject to more regulation, as Rubin did, or had faith in the discipline of the market (Greenspan’s position). Consider how the market might have reacted if the President’s Working Group had put out a statement saying they supported the CFTC in issuing its concept release. The legal uncertainty than would have been much greater. The reason for issuing the Rubin, Levitt, Greenspan statement was to provide reassurance to the market in order to prevent an adverse reaction to what the CFTC had done.
Rubin had proposed to Born that, instead of the CFTC asking questions about the need for regulation of the OTC derivatives market, the President’s Working Group on Financial Markets issue the questions. Born point blank refused this suggestion, thus pushing Rubin into Greenspan’s camp, much to the relief of ISDA and other Wall Street groups lobbying on this issue. They knew they had a problem with Rubin.
Brooksley Born was so sure she was right in her legal position that she could not compromise in face of the practical and political realities. While, not to make too fine a point about it, she has been proven right and Greenspan wrong about the dangers of the OTC derivatives market, Greenspan was the better politician. History might have been different if Born had agreed to Rubin’s suggestion.