SEC/CFTC Harmonization Panel Urges Continued Use of Derivatives

At the recent meeting on the harmonization of regulation between the SEC and CFTC, former CFTC Chair Sharon Brown-Hruska said that she does not understand the panic-stricken reaction to credit default swaps (“CDSs”). Except for CDSs for mortgage-backed securities, the CDS market has performed well, she said. Brown-Hruska was one several experts that discussed harmonization as it relates to investment funds.

Brown-Hruska said that proposals for a wholesale restructuring of the derivatives market go well beyond what is needed. Lawmakers should look at regulation of over-the-counter (“OTC”) derivatives in the context of systemic risk, and should consider regulating more forcefully in this area, she said. However, she is concerned about ongoing discussions regarding a ban on CDSs. They are vital to the liquidity of the markets, she said.

Former Congressman Richard Baker, who is now the president and CEO of the Managed Funds Association (“MFA”), said that CDSs have been used inappropriately at times, but are not a bad product. They serve a very useful business purpose, he said.

On the topic of regulatory harmonization, Baker said that the MFA favors simplification of the registration requirements for, and regulation of, market participants whose activities in the OTC derivates markets are systemically significant. The association also would like to see consistent regulation of OTC derivative products within asset classes, and the creation of a central trade repository to streamline the reporting of trades and other transaction information as part of an OTC derivatives reporting system.

Michael Connelly, vice chairman of the board of directors of the Association of Financial Professionals (“AFP”) and treasurer of Tiffany & Co., favors the enhancement of derivatives regulation, but fears that it will be too focused on the speculative uses of derivatives. He wants lawmakers to preserve the prudent use of OTC derivatives. New regulations should not come at the cost of proven risk-management tools, he said.

Connelly said that AFP supports eliminating regulatory uncertainty about which agency regulates which financial instruments. Companies that use derivatives to manage their risks must have certainty about the legal and regulatory framework under which they operate, he noted.

Connelly also addressed the proposal to improve oversight and transparency of the OTC derivatives market by requiring the reporting of all derivative trades to either a central counterparty (for standardized OTC derivatives) or to a regulated trade repository (for non-standardized OTC derivatives). AFP supports the mandatory reporting proposal, he said, but believes the reporting should be done by the major market participant involved in the transaction rather than by the corporation that executes derivatives trades only occasionally. Companies would have to develop an infrastructure to meet the proposed reporting requirements, he noted, and the added costs would provide a disincentive for companies to manage their business risks effectively.

Kathleen Moriarty, a partner at Katten Muchin Rosenman, acknowledged that a merger of the SEC and CFTC is highly unlikely, and so expressed her support for joint compliance examinations and the joint registration of investment professionals. In a perfect world, all financial products would be regulated by a single agency, she said, but that is not likely to happen given the significant and coordinated changes to both commodities and securities laws that would be required.

Moriarty believes that the Investment Company Act is the existing statute best suited to review and regulate pooled vehicles. Although the Act excludes commodities from the definition of securities that can be held by an investment company, there is no prohibition against including commodities in the portfolio of an investment company, she noted.

As a result, Moriarty proposed that the agencies use the existing exemptive order process under Section 6(c) to create a series of approved structures for exchange-traded vehicles investing in commodities. If this were to happen, she said, then all pooled investment vehicles offered to the public, regardless of their portfolio assets, would be subject to the same regulatory scheme, would provide comparable disclosure documents, would use advisers with fiduciary obligations to their clients, and would be subject to review by regulators familiar with the potential for abuse presented by the portfolio entities.