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).)