A point I have been trying to make is that the financial crisis was partly due to a failure of the federal financial regulators to use their existing authority, not that they did not have sufficient authority. Unfortunately, the current legislative proposals do not address the causes of this regulatory failure and may, in fact, compound it.
The legislative proposals contain some worthwhile provisions. Even resolution authority, though it may not prevent all future “bailouts,” nothing can be done to prevent that, is a useful tool for the regulators to have, given that the Bankruptcy Code has some problems in dealing with financial institution insolvency. A consumer protection agency is also needed, given how many people were offered mortgages inappropriate to their financial situation.
However, while it may be good public policy to force interest rate swaps to trade on exchanges and into clearinghouses (this can be debated), this has nothing to do with addressing the issues raised by the financial crisis. A provision that states that there will be no federal bailout ever of a derivatives clearinghouse is not useful. It is political window dressing. No futures clearinghouse in the U.S. has failed, but if a large one, say the CME, was about to, the consequences of not doing anything would be devastating. (A CME failure may be unlikely, but it is not impossible.) The federal government would do something, and, if need be, laws would be changed.
Concerning the regulators, the usual argument for not making any changes is that, while no one would design our current system from scratch, the numerous regulators have learned to work with each other and to make it work. But the current system did not work during the period leading up to the crisis.
In times of crisis, the regulators work well together because they face a common problem and all feel a responsibility to do all they can to resolve the crisis. It is in other periods that regulatory cooperation is less than it should be. The agencies often bicker bitterly over policy and turf issues. In the meantime, significant developments are missed, such as the growing CDO market resulting in banks laying off risk and concentrating at AIG. Moreover, the current proposals may serve to increase discord, especially as new products are developed and it is far from clear which regulatory agency has the lead role.
In addition, there are the issues of regulatory capture and other agency goals, such as monetary policy. The Fed could have used it authority to rein in the extremely loose underwriting standards for home mortgages and the complexity of the mortgages being offered to borrowers whose only hope of not defaulting was a continuing increase in real estate prices. The bank regulators and the SEC could have reined in the use of off-balance sheet SIVs and the issuance of synthetic CDOs, and they could have aggressively questioned the appropriateness of the ratings of some of the new instruments and their use in various capital rules.
More serious consideration should be given to regulatory restructuring. Also, in some cases, regulatory discretion may need to minimized. Proposals such as the “Volcker” rule and capping the size of banks do that.
Unfortunately, there seems to be a dearth of serious analysis of the causes of the financial crisis and how best to restructure both the regulators and the financial system. And while the crisis started in the housing market, the current focus is on the OTC derivatives market, which played a role but is far from the whole story. The political necessity is to show that the government is getting tough on Wall Street and to enact something before the next election. However, once we have entered into a period with no apparent, major problems (the European situation could cause some serious problems in the near future), the Wall Street interests will attempt to start whittling away at the most inconvenient aspects of the new law or laws. In some cases, they may be right and in others it will be pure self-interest. I have no doubt, though, that whatever the rules are, major Wall Street players will find ways to adapt and be highly profitable.
Friday, April 30, 2010
Thursday, April 29, 2010
The Wall Street Transparency and Accountability Act – Foreign Currency, Government Securities, and the Treasury Amendment
I have been looking at the derivatives language that the Senate Agriculture Committee has contributed to what will be called if it is enacted “The Wall Street Transparency and Accountability Act of 2010.” Particularly, I have been trying to figure out what the legislation does to the foreign exchange and government securities market, which had been excluded from CFTC jurisdiction except for transactions conducted on an organized exchange. (The SEC has jurisdiction on foreign currency options trading on a securities exchanges, and the exclusion does not apply to retail transactions in foreign currency.)
As way of background, one of the reasons the Treasury and the CFTC battled each other during the 80s and 90s had to do with a provision of the Commodity Exchange Act (“CEA”) known as the Treasury Amendment. Except for certain transactions conducted on a “board of trade,” this amendment to the 1974 legislation creating the CFTC excluded transactions in government securities, foreign currency, and some other items from CFTC jurisdiction. In the 80s and 90s, the CFTC had two areas of concern which, from Treasury’s point of view, could compromise the Treasury Amendment. First, the CFTC was going after foreign currency scams in the U.S., which often targeted immigrant communities in the U.S. Second, it at times took a broad view of what constituted a “futures contract” because of the growing swaps market and “hybrid instruments,” such as securities with embedded derivatives (for example, indexation to the price of oil.)
The Treasury had two principal concerns. First, the Treasury wanted to keep the when-issued (“wi”) market for Treasury securities free from CFTC regulation. This market is important for Treasury in auctioning its securities. Moreover, in 1986, Treasury had been given the responsibility by the Government Securities Act to write rules for all government securities dealers and brokers (including commercial banks), with the rules being enforced by the appropriate regulatory agency (the SEC and the bank regulators). If the CFTC had authority over the wi market, this would cut into Treasury’s authority, since, under the CEA, the CFTC has “exclusive jurisdiction.”
In addition, the Treasury did not want the CFTC asserting authority over portions of the foreign exchange market. The Treasury has the responsibility to establish U.S. foreign exchange policy.
One of the legal theories that the CFTC was using in the retail foreign currency cases was that the operators were “boards of trade” and thus the transactions in questions were not excluded by the Treasury Amendment. (The CEA at the time did not distinguish between retail and wholesale transactions for these purposes.) If these entities were boards of trade, the interdealer brokers, through which government securities dealers trade could also be viewed as boards of trade, and wi trades might not be eligible for the exclusion for forward contracts, since many of the wi trades are offset. Even though the CFTC never made any move to assert jurisdiction over this market, the Treasury was concerned that there was a legal argument that could be made that the Treasury Amendment did not apply to this market. Treasury offered to work with the CFTC to craft language explicitly giving it authority over retail foreign currency options and futures, but the CFTC spurned these suggestions until it lost a 1997 Supreme Court case on the Treasury Amendment (Dunn v. CFTC).
That case involved options on foreign currency. The CFTC argued that options were not covered by the Treasury Amendment because they were not transactions “in” foreign currency but transactions “involving” foreign currency. The Supreme Court disagreed with this argument 9 to 0.
The current legislation before the Senate whittles away at what remains of the Treasury Amendment by subjecting foreign exchange transactions to CFTC regulation unless the Secretary of the Treasury explicitly exempts them. The legislation appears to keep in place the exclusion from most provisions of the CEA for foreign currency transactions. I have not found language that differentiates between foreign currency and foreign exchange.
Concerning government securities, the legislation also appears to keep in place the exclusion from most provisions of the CEA if not conducted on an exchange. I am not sure, though, whether the interdealer brokers and the Fixed Income Clearing Corporation might be potentially affected by their activities with respect to wi trades, which can be said to resemble traditional futures contracts.
There are a myriad more details that interested parties need, including government agencies, need to keep on top of as the legislation progresses. When something is enacted, as seems likely, there will probably be a need for a “technical corrections” bill to correct the mistakes.
As way of background, one of the reasons the Treasury and the CFTC battled each other during the 80s and 90s had to do with a provision of the Commodity Exchange Act (“CEA”) known as the Treasury Amendment. Except for certain transactions conducted on a “board of trade,” this amendment to the 1974 legislation creating the CFTC excluded transactions in government securities, foreign currency, and some other items from CFTC jurisdiction. In the 80s and 90s, the CFTC had two areas of concern which, from Treasury’s point of view, could compromise the Treasury Amendment. First, the CFTC was going after foreign currency scams in the U.S., which often targeted immigrant communities in the U.S. Second, it at times took a broad view of what constituted a “futures contract” because of the growing swaps market and “hybrid instruments,” such as securities with embedded derivatives (for example, indexation to the price of oil.)
The Treasury had two principal concerns. First, the Treasury wanted to keep the when-issued (“wi”) market for Treasury securities free from CFTC regulation. This market is important for Treasury in auctioning its securities. Moreover, in 1986, Treasury had been given the responsibility by the Government Securities Act to write rules for all government securities dealers and brokers (including commercial banks), with the rules being enforced by the appropriate regulatory agency (the SEC and the bank regulators). If the CFTC had authority over the wi market, this would cut into Treasury’s authority, since, under the CEA, the CFTC has “exclusive jurisdiction.”
In addition, the Treasury did not want the CFTC asserting authority over portions of the foreign exchange market. The Treasury has the responsibility to establish U.S. foreign exchange policy.
One of the legal theories that the CFTC was using in the retail foreign currency cases was that the operators were “boards of trade” and thus the transactions in questions were not excluded by the Treasury Amendment. (The CEA at the time did not distinguish between retail and wholesale transactions for these purposes.) If these entities were boards of trade, the interdealer brokers, through which government securities dealers trade could also be viewed as boards of trade, and wi trades might not be eligible for the exclusion for forward contracts, since many of the wi trades are offset. Even though the CFTC never made any move to assert jurisdiction over this market, the Treasury was concerned that there was a legal argument that could be made that the Treasury Amendment did not apply to this market. Treasury offered to work with the CFTC to craft language explicitly giving it authority over retail foreign currency options and futures, but the CFTC spurned these suggestions until it lost a 1997 Supreme Court case on the Treasury Amendment (Dunn v. CFTC).
That case involved options on foreign currency. The CFTC argued that options were not covered by the Treasury Amendment because they were not transactions “in” foreign currency but transactions “involving” foreign currency. The Supreme Court disagreed with this argument 9 to 0.
The current legislation before the Senate whittles away at what remains of the Treasury Amendment by subjecting foreign exchange transactions to CFTC regulation unless the Secretary of the Treasury explicitly exempts them. The legislation appears to keep in place the exclusion from most provisions of the CEA for foreign currency transactions. I have not found language that differentiates between foreign currency and foreign exchange.
Concerning government securities, the legislation also appears to keep in place the exclusion from most provisions of the CEA if not conducted on an exchange. I am not sure, though, whether the interdealer brokers and the Fixed Income Clearing Corporation might be potentially affected by their activities with respect to wi trades, which can be said to resemble traditional futures contracts.
There are a myriad more details that interested parties need, including government agencies, need to keep on top of as the legislation progresses. When something is enacted, as seems likely, there will probably be a need for a “technical corrections” bill to correct the mistakes.
Sunday, April 25, 2010
Bankruptcy and Close-out Netting of Financial Contracts
The Bankruptcy Code contains provisions for close-out netting of financial contracts. Explaining these provisions entirely would make for a long and boring post, but suffice it to say that for certain types of financial contracts, e.g., repos, securities contracts, forward contracts, and swaps, there is an exception from the automatic stay of the Code. This means, with some exceptions, that counterparties to a institution that has filed for bankruptcy are permitted to net and liquidate these contracts with the failed institution immediately. This is an exception to the general rule that creditors are not permitted to take this type of action until the bankruptcy court has approved such action.
The public policy justification for these provisions is the claim that they reduce systemic risk. It was argued that in fast moving markets in which financial intermediaries may need the proceeds from one transaction to pay off another, waiting for a court to lift a stay could cause a domino effect, thus spreading financial problems to other firms, even those that had no trades with the failing firm.
When it comes to the failure of firms with large positions, there is now the fear that close-out netting could also cause problems. If, upon the filing of bankruptcy of a large hedge fund or investment bank, all the counterparties liquidate eligible financial contracts and sell the collateral in their possession supporting these positions at the same time, this could cause market problems.
This is one of the reasons the Administration has proposed resolution authority. Under current law, the FDIC has one business day to decide what to do about “qualified financial contracts.” It can decide to transfer these contracts to a willing, solvent institution, and the counterparties would then not liquidate the contracts and the underlying collateral.
However, there is some doubt that resolution authority would work for multinational financial institutions. Other countries would deal with those parts of the institution in their own way under their own laws. That is one reason why ad hoc responses to any future crises involving the insolvency of a large financial institution are likely, no matter what legislation is passed now or what promises are made.
Attention needs to be focused on making such crises less likely. Proposals being put forward include more stringent regulation, tougher capital requirements, limiting the permissible business activities of certain types of financial institutions, and capping the size of banks and forcing current large bank holding companies to split into smaller pieces. The aim now, though, seems to be to pass anything that can be passed, in order to say that the government is addressing the issues raised by the financial crisis. We can at least all hope that this political reality will result in legislation that will improve the financial system.
The public policy justification for these provisions is the claim that they reduce systemic risk. It was argued that in fast moving markets in which financial intermediaries may need the proceeds from one transaction to pay off another, waiting for a court to lift a stay could cause a domino effect, thus spreading financial problems to other firms, even those that had no trades with the failing firm.
When it comes to the failure of firms with large positions, there is now the fear that close-out netting could also cause problems. If, upon the filing of bankruptcy of a large hedge fund or investment bank, all the counterparties liquidate eligible financial contracts and sell the collateral in their possession supporting these positions at the same time, this could cause market problems.
This is one of the reasons the Administration has proposed resolution authority. Under current law, the FDIC has one business day to decide what to do about “qualified financial contracts.” It can decide to transfer these contracts to a willing, solvent institution, and the counterparties would then not liquidate the contracts and the underlying collateral.
However, there is some doubt that resolution authority would work for multinational financial institutions. Other countries would deal with those parts of the institution in their own way under their own laws. That is one reason why ad hoc responses to any future crises involving the insolvency of a large financial institution are likely, no matter what legislation is passed now or what promises are made.
Attention needs to be focused on making such crises less likely. Proposals being put forward include more stringent regulation, tougher capital requirements, limiting the permissible business activities of certain types of financial institutions, and capping the size of banks and forcing current large bank holding companies to split into smaller pieces. The aim now, though, seems to be to pass anything that can be passed, in order to say that the government is addressing the issues raised by the financial crisis. We can at least all hope that this political reality will result in legislation that will improve the financial system.
Our Dysfunctional Financial Regulatory Structure
One of the disheartening aspects of the financial regulatory reform effort is that there is currently little discussion of how to fix a regulatory system that is structured haphazardly and is often dysfunctional. The current structure, as most everyone who looks at it concedes, is not something one would construct from scratch; it is the result of historical reaction to crises and other pressures.
One example is the current division of responsibilities between the SEC and the CFTC. Why is it logical that the SEC regulate options on securities and security indices, the CFTC regulate futures on broad-based security indices and options on these futures contracts, and that they share jurisdiction on futures on narrow-based (non-exempt) security indices and futures on single (non-exempt) securities? The CFTC also has sole authority over futures on government securities, even if it is a single issue of T-bills.
The SEC and the CFTC have had many disputes, though many of the most contentious issues between them have been resolved. With the enactment of any legislation that is vague on the dividing line between the two agencies on OTC derivatives and between them and the bank regulators, new disputes among regulatory agencies are likely.
All the financial regulators had problems with the CFTC during the 1980s and 1990s, because of the vagueness of the Commodity Exchange Act and its exclusive jurisdiction provision. The much maligned Commodity Futures Modernization Act (“CFMA”) resolved many of these problems, but derivatives legislation could cause new problems if not well written. For an example of a badly written legislative draft, one need look no further than Treasury’s original proposal.
(The common wisdom at the moment is that the CFMA was a major cause of the financial crisis. This can be debated, but what is clear is that the regulators did not use the authority they had to rein in excesses. The housing bubble was not caused by the CFMA; synthetic collateralized debt obligations are securities subject to SEC jurisdiction; and significant leverage of banks and bank holding companies and their exposures through credit default swaps to AIG could have been considered unsafe and unsound banking practices.)
The Gramm-Leach-Bliley Act caused a major dispute between the SEC and the bank regulators. The dispute was over the permissible security activities of bank trust departments without triggering the registration requirements of the Securities Exchange Act. This dispute, which I was not involved in but knew some of the participants on both sides, became vicious and, unfortunately, at times personal. This is not conducive to good working relationships among agencies.
The OCC has a conflict of interest in regulating banks, since its budget, unlike that of the SEC, is determined by the amount of fees it collects. If a bank opts out of a national charter and chooses a state charter, the OCC has less money to spend. One might suspect that this serves as an incentive for the OCC to make the national charter as attractive as possible.
The bank regulators (OCC, FDIC, Fed, OTS) have squabbled over capital rules. The agencies have different interests. For example, the FDIC is concerned, as it should be, with preventing situations from arising that would generate large payments from its insurance funds; the OCC, as mentioned, wants to be helpful within reason to the banks; and the Fed arguably has general monetary policy and financial system concerns.
Some disagreement among agencies can be healthy; better policies can result out of debate and compromise. Also, during times of crisis, the agencies normally do cooperate and work well with each other. It is the period before the crisis happens that I am concerned about. At times, the discord between the agencies has been unhealthy, and competition among agencies may have led to regulation that was too permissive.
It is not easy to determine the optimum regulatory structure. The U.K. some years ago decided to consolidate financial regulatory authority in a single regulator, the Financial Services Authority (“FSA”). That did not work out that well either, and the Conservatives plan to give some regulatory authority back to the Bank of England should they win the election.
However, the split between the SEC and the CFTC is hard to justify as the economic purposes of some of the instruments they regulate have become very similar. It is also hard to justify the number of bank regulators. One could look also at a number of smaller regulators, such the National Credit Union Administration, the Federal Housing Finance Agency, and the Farm Credit Administration. The regulatory role of the Fed is one aspect of reform that has been thought about, but I am not sure that it has been explored analytically as much as it should.
Regulatory dysfunction has been a problem, and the current legislative proposals, while rearranging and adding responsibilities, merging the OTS into the OCC, and creating a new consumer protection agency, are not seriously addressing it.
One example is the current division of responsibilities between the SEC and the CFTC. Why is it logical that the SEC regulate options on securities and security indices, the CFTC regulate futures on broad-based security indices and options on these futures contracts, and that they share jurisdiction on futures on narrow-based (non-exempt) security indices and futures on single (non-exempt) securities? The CFTC also has sole authority over futures on government securities, even if it is a single issue of T-bills.
The SEC and the CFTC have had many disputes, though many of the most contentious issues between them have been resolved. With the enactment of any legislation that is vague on the dividing line between the two agencies on OTC derivatives and between them and the bank regulators, new disputes among regulatory agencies are likely.
All the financial regulators had problems with the CFTC during the 1980s and 1990s, because of the vagueness of the Commodity Exchange Act and its exclusive jurisdiction provision. The much maligned Commodity Futures Modernization Act (“CFMA”) resolved many of these problems, but derivatives legislation could cause new problems if not well written. For an example of a badly written legislative draft, one need look no further than Treasury’s original proposal.
(The common wisdom at the moment is that the CFMA was a major cause of the financial crisis. This can be debated, but what is clear is that the regulators did not use the authority they had to rein in excesses. The housing bubble was not caused by the CFMA; synthetic collateralized debt obligations are securities subject to SEC jurisdiction; and significant leverage of banks and bank holding companies and their exposures through credit default swaps to AIG could have been considered unsafe and unsound banking practices.)
The Gramm-Leach-Bliley Act caused a major dispute between the SEC and the bank regulators. The dispute was over the permissible security activities of bank trust departments without triggering the registration requirements of the Securities Exchange Act. This dispute, which I was not involved in but knew some of the participants on both sides, became vicious and, unfortunately, at times personal. This is not conducive to good working relationships among agencies.
The OCC has a conflict of interest in regulating banks, since its budget, unlike that of the SEC, is determined by the amount of fees it collects. If a bank opts out of a national charter and chooses a state charter, the OCC has less money to spend. One might suspect that this serves as an incentive for the OCC to make the national charter as attractive as possible.
The bank regulators (OCC, FDIC, Fed, OTS) have squabbled over capital rules. The agencies have different interests. For example, the FDIC is concerned, as it should be, with preventing situations from arising that would generate large payments from its insurance funds; the OCC, as mentioned, wants to be helpful within reason to the banks; and the Fed arguably has general monetary policy and financial system concerns.
Some disagreement among agencies can be healthy; better policies can result out of debate and compromise. Also, during times of crisis, the agencies normally do cooperate and work well with each other. It is the period before the crisis happens that I am concerned about. At times, the discord between the agencies has been unhealthy, and competition among agencies may have led to regulation that was too permissive.
It is not easy to determine the optimum regulatory structure. The U.K. some years ago decided to consolidate financial regulatory authority in a single regulator, the Financial Services Authority (“FSA”). That did not work out that well either, and the Conservatives plan to give some regulatory authority back to the Bank of England should they win the election.
However, the split between the SEC and the CFTC is hard to justify as the economic purposes of some of the instruments they regulate have become very similar. It is also hard to justify the number of bank regulators. One could look also at a number of smaller regulators, such the National Credit Union Administration, the Federal Housing Finance Agency, and the Farm Credit Administration. The regulatory role of the Fed is one aspect of reform that has been thought about, but I am not sure that it has been explored analytically as much as it should.
Regulatory dysfunction has been a problem, and the current legislative proposals, while rearranging and adding responsibilities, merging the OTS into the OCC, and creating a new consumer protection agency, are not seriously addressing it.
Friday, April 23, 2010
The Fight Over OTC Derivatives Regulation: Some History and Implications
As the U.S. Senate considers financial regulatory reform, an important thing to remember about regulation is that it sometimes turns out not to serve the purpose for which it was originally intended. Sometimes it serves the regulated entities by creating barrier to entry and by their ability to “capture” their regulatory agencies. Liberals in particular should keep this in mind as various regulatory proposals are considered.
For example, the fight over the legal status of OTC derivatives which became ferocious during the 1990s was in large part a fight between the futures exchanges and the OTC derivatives dealers (major commercial and investment banks). The futures exchanges, principally the Chicago Board of Trade (“CBT”) and the Chicago Mercantile Exchange (“CME”), since merged, feared the competition of OTC derivatives dealers with such products as interest rate swaps. The OTC derivatives dealers argued, to no avail, that the OTC derivatives market brought business to the futures exchanges, since they hedged their derivatives book with exchange-traded futures contracts.
The reason that the futures exchanges could use the Commodity Exchange Act (“CEA”) and their regulator, the CFTC, to attack the OTC derivatives dealers goes back to changes made in the CEA in the 1970s. These changes created the CFTC and made its jurisdiction much broader than its predecessor agency, the Commodity Exchange Authority, which was part of the Department of Agriculture.
When the Bretton Woods system was breaking down in 1971, the CME decided to offer futures contracts on foreign currency on a newly created division they called the International Monetary Market. These contracts were unregulated, since the Commodity Exchange Authority was essentially limited to regulating futures and options contracts on a list of agricultural commodities.
In order to deal with this issue and to make certain that there would not be any unregulated futures contracts, the Commodity Futures Trading Commission Act of 1974 appended to the list of agricultural commodities catchall language: “... all other good and articles, except onions..., and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”
To enhance the CFTC’s authority over these contracts, the CFTC was granted “exclusive jurisdiction” over “transactions involving the sale of a commodity for future delivery” and options “involving” such contracts. The exact meaning of this was unclear since the phrase “sale of a commodity for future delivery” is not defined, and there is the so-called “forward contract exclusion” from the CEA – “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery.”
The stage was set for jurisdictional problems between the CFTC and other regulators. The first regulatory dispute involved the SEC, in particular with respect to options and futures on securities. This led to the Shad-Johnson Accord in December 1981, named after the then chairmen of the SEC and the CFTC. This resolved the current issues between the two agencies, but it was obvious to observers, including those of us at Treasury, that there would be future disagreements.
The broad definition of commodity was meant to make sure that there were no unregulated futures contracts and the exclusive jurisdiction provision was meant to serve as a shield for the futures exchanges against other regulators and state laws, such as gaming statutes. This combined with the lack of definition of the types of contracts to which the CEA applied gave the futures exchanges a sword to attack the OTC derivatives market.
Complicating matters is that, while the CFTC had the authority to permit commodity options to trade off an exchange, they did not have the authority to allow this for futures contracts. Therefore, if some OTC derivatives were futures contracts, they were illegal and unenforceable. The OTC derivatives dealers were well aware of this, and as time went on, the CFTC was given exemptive authority for many types of swaps (though not those based on equity and other non-exempt securities) in order to remove this threat from the market. The strategy of the OTC derivatives dealers was to maintain that the CEA did not apply and with a very large market for the new instruments making the argument that it was too dangerous to apply. This strategy worked.
Whatever one thinks of the relative merits of OTC derivatives and exchange-traded futures contracts or who was right on the law, it goes almost without saying that the OTC derivatives dealers and the futures exchanges were fighting for what they perceived to be their economic interests. Both groups were able to get the support of their regulators.
Ultimately, the Commodity Futures Modernization Act of 2000 was made possible by a deal made between the futures exchanges and the OTC derivatives dealers. By this time, the futures exchanges knew they could not kill the OTC derivatives market, and the OTC derivatives dealers knew that the futures exchanges could probably block any legislation giving them the “legal certainty” they wanted. The deal was that the futures exchanges would not block legal certainty for OTC derivatives if the legislation also included provisions lightening CFTC regulation of the futures exchanges.
Some points to note here. Initially, the debate was not about “regulating” OTC derivatives. It was about banning them, thus benefitting one industry group over another. Also, the banking regulators had defined swaps to be a banking activity and thus permitted. The banking regulators had authority over the derivatives activities of banks. The arguments among the industry groups also became a strenuous argument among the regulators, with the SEC and the CFTC filing opposing briefs in court cases. This contributed to a dysfunctional regulatory system, characterized by way too many regulators, some partially captured, who spend too much time arguing among themselves.
For regulatory reform to be successful, it should not just be an effort to give regulators more authority or banning certain types of instruments. After all, the regulators did not use their authority very well during the period leading up to the financial crisis. One needs to think about how the government should be organized to regulate the financial markets and industry and how the industry itself should be structured. For example, perhaps the permissible activities of commercial banks should be limited or there should be means to discourage organizations from growing larger than a certain size. These are difficult issues, both politically and substantively.
One should also be clear about what the goals are. The main ones should be reducing systemic risk and excessive leverage and providing greater customer protection. Other items will inevitably be added; various groups and government agencies have a wish list of items and the legislative effort provides an opportunity. These should be scrutinized carefully, because noble sounding policy goals could be shrouding something else and may have unintended consequences.
(I go more into the history of the problems between the SEC and the CFTC in an article I wrote – “The March 11 Memorandum of Understanding Between the SEC and the CFTC,” Journal of Taxation of Financial Products (vol. 7, issue 3, 2008).)
For example, the fight over the legal status of OTC derivatives which became ferocious during the 1990s was in large part a fight between the futures exchanges and the OTC derivatives dealers (major commercial and investment banks). The futures exchanges, principally the Chicago Board of Trade (“CBT”) and the Chicago Mercantile Exchange (“CME”), since merged, feared the competition of OTC derivatives dealers with such products as interest rate swaps. The OTC derivatives dealers argued, to no avail, that the OTC derivatives market brought business to the futures exchanges, since they hedged their derivatives book with exchange-traded futures contracts.
The reason that the futures exchanges could use the Commodity Exchange Act (“CEA”) and their regulator, the CFTC, to attack the OTC derivatives dealers goes back to changes made in the CEA in the 1970s. These changes created the CFTC and made its jurisdiction much broader than its predecessor agency, the Commodity Exchange Authority, which was part of the Department of Agriculture.
When the Bretton Woods system was breaking down in 1971, the CME decided to offer futures contracts on foreign currency on a newly created division they called the International Monetary Market. These contracts were unregulated, since the Commodity Exchange Authority was essentially limited to regulating futures and options contracts on a list of agricultural commodities.
In order to deal with this issue and to make certain that there would not be any unregulated futures contracts, the Commodity Futures Trading Commission Act of 1974 appended to the list of agricultural commodities catchall language: “... all other good and articles, except onions..., and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”
To enhance the CFTC’s authority over these contracts, the CFTC was granted “exclusive jurisdiction” over “transactions involving the sale of a commodity for future delivery” and options “involving” such contracts. The exact meaning of this was unclear since the phrase “sale of a commodity for future delivery” is not defined, and there is the so-called “forward contract exclusion” from the CEA – “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery.”
The stage was set for jurisdictional problems between the CFTC and other regulators. The first regulatory dispute involved the SEC, in particular with respect to options and futures on securities. This led to the Shad-Johnson Accord in December 1981, named after the then chairmen of the SEC and the CFTC. This resolved the current issues between the two agencies, but it was obvious to observers, including those of us at Treasury, that there would be future disagreements.
The broad definition of commodity was meant to make sure that there were no unregulated futures contracts and the exclusive jurisdiction provision was meant to serve as a shield for the futures exchanges against other regulators and state laws, such as gaming statutes. This combined with the lack of definition of the types of contracts to which the CEA applied gave the futures exchanges a sword to attack the OTC derivatives market.
Complicating matters is that, while the CFTC had the authority to permit commodity options to trade off an exchange, they did not have the authority to allow this for futures contracts. Therefore, if some OTC derivatives were futures contracts, they were illegal and unenforceable. The OTC derivatives dealers were well aware of this, and as time went on, the CFTC was given exemptive authority for many types of swaps (though not those based on equity and other non-exempt securities) in order to remove this threat from the market. The strategy of the OTC derivatives dealers was to maintain that the CEA did not apply and with a very large market for the new instruments making the argument that it was too dangerous to apply. This strategy worked.
Whatever one thinks of the relative merits of OTC derivatives and exchange-traded futures contracts or who was right on the law, it goes almost without saying that the OTC derivatives dealers and the futures exchanges were fighting for what they perceived to be their economic interests. Both groups were able to get the support of their regulators.
Ultimately, the Commodity Futures Modernization Act of 2000 was made possible by a deal made between the futures exchanges and the OTC derivatives dealers. By this time, the futures exchanges knew they could not kill the OTC derivatives market, and the OTC derivatives dealers knew that the futures exchanges could probably block any legislation giving them the “legal certainty” they wanted. The deal was that the futures exchanges would not block legal certainty for OTC derivatives if the legislation also included provisions lightening CFTC regulation of the futures exchanges.
Some points to note here. Initially, the debate was not about “regulating” OTC derivatives. It was about banning them, thus benefitting one industry group over another. Also, the banking regulators had defined swaps to be a banking activity and thus permitted. The banking regulators had authority over the derivatives activities of banks. The arguments among the industry groups also became a strenuous argument among the regulators, with the SEC and the CFTC filing opposing briefs in court cases. This contributed to a dysfunctional regulatory system, characterized by way too many regulators, some partially captured, who spend too much time arguing among themselves.
For regulatory reform to be successful, it should not just be an effort to give regulators more authority or banning certain types of instruments. After all, the regulators did not use their authority very well during the period leading up to the financial crisis. One needs to think about how the government should be organized to regulate the financial markets and industry and how the industry itself should be structured. For example, perhaps the permissible activities of commercial banks should be limited or there should be means to discourage organizations from growing larger than a certain size. These are difficult issues, both politically and substantively.
One should also be clear about what the goals are. The main ones should be reducing systemic risk and excessive leverage and providing greater customer protection. Other items will inevitably be added; various groups and government agencies have a wish list of items and the legislative effort provides an opportunity. These should be scrutinized carefully, because noble sounding policy goals could be shrouding something else and may have unintended consequences.
(I go more into the history of the problems between the SEC and the CFTC in an article I wrote – “The March 11 Memorandum of Understanding Between the SEC and the CFTC,” Journal of Taxation of Financial Products (vol. 7, issue 3, 2008).)
Saturday, April 10, 2010
The CFTC and OTC Derivatives: The Importance of Political Competence
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.
Financial Crisis Inquiry Commission Hearings , OTC Derivatives, Rubin and Born
This week I watched some of the hearing of the Financial Crisis Inquiry Commission. The commissioners appeared to be working together better than I would have thought given the Commission's composition. The two Californians in charge, Phil Angelides (D) and Bill Thomas(R) appear to get along. The two commissioners who I know have strong and different opinions about regulation and OTC derivatives, former CFTC chair Brooksley Born and Peter Wallison of AEI and a former Treasury Department general counsel (in the Reagan Administration), kept any hostility they might have towards each other in check.
I still wonder where this exercise is going. With the witnesses, the commissioners seemed more intent on scoring points rather than establishing facts that would lead to an analysis of the underlying causes of the crisis. There was an element of a show trial, which is not unusual at this venue, a Congressional hearing room. And some of the witnesses do in fact have quite a bit to answer for.
On one point, I want to come to the defense of former Secretary Rubin. I have no knowledge other than what I read in the press about his career since he left Treasury, but with respect to his concerns about OTC derivatives during the Clinton Administration, I have personal knowledge that his statements about this to the Commission are correct, even though professional sarcasm dispenser Dana Millbank of the Washington Post and most certainly others have mocked Rubin.
(From a recent online chat: Q. How does Robert Rubin have the chutzpah to say he didn't resist the regulation of derivatives to a panel with Brooksly Born on it?
A. I guess the same way Greenspan had the nerve to tell the same commission that he was warning everybody about the subprime mortgage collapse years before it happened. There is a very strange electromagnetic field or something in that hearing room, which I think explains why the power went out during Wednesday's session.)
At the hearing, Rubin said he was concerned about the risks that OTC derivatives posed to the financial system when he was in the Clinton Administration. Having been in meetings with him when he was both head of the NEC and when he was Secretary, I can attest that this is true. He also said that he was concerned about legal issues that might threaten the market if the CFTC were to assert jurisdiction over the market. I was one of the Treasury staffers making this point at the time.
Brooksley Born was undoubtedly right about the potential for problems with these instruments. As I have previously written, she could have probably been able to make allies of Rubin and SEC chairman Arthur Levitt, if she had not insisted that the Commodity Exchange Act be used as the applicable statute for regulating this market.
She and her chief aide on this subject, Michael Greenberger (former CFTC Director of the Division of Trading and Markets), effectively wanted to change the name of the Commodity Futures Trading Commission to something like the Derivatives Commission. In public pronouncements, Greenberger would say that the CFTC was the derivatives regulator.
To some this would appear to be simply a turf fight, and it was partly that. The bank regulators and, to an extent, the SEC did not want the CFTC imposing rules and examining entities that they viewed as under their jurisdiction. But there was also a serious legal issue involved that threatened the enforceability of some contracts. I have likened it to a sword of Damocles. More about this in my next post.
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