(The article featured below is a selection from Hedge Funds and Private Equity: Risk Management and Regulatory Update, which is available to subscribers of that publication.)

SEC Requests Changes in House Draft Derivatives Legislation to Prevent Regulatory Arbitrage

While praising the House Financial Services Committee’s draft legislation to regulate the OTC-derivatives markets, the SEC warned that the draft could present opportunities for significant regulatory arbitrage. In testimony before the committee, Henry T.C. Hu, Director of the Risk, Strategy and Financial Innovation Division, said that the draft adopts a distinction that is not meaningful between derivatives referencing a single security or a narrow-based index of securities and derivatives referencing a broad-based index of securities. The SEC cautioned that a market participant could use a broad-based swap as part of a strategy to gain highly targeted exposure to a single company or a narrow group of companies.

In addition, the draft could result in regulatory differences between swaps products and currently regulated securities and futures products. For example, energy swaps would not be regulated in the same way as energy futures, he noted, and securities swaps would not be regulated in the same way as securities. The differences come from the fact that the draft sets up a new regulatory scheme for swaps and securities swaps.

Focused as it is on minimizing differences in the regulation of swaps and security-based swaps, this scheme would be different from the regulations applicable to securities or futures. In the SEC's view, this is significant because market players evaluating whether to engage in a swap transaction are far more likely to focus on the choice between a swap and a regulated alternative.

These differences could perpetuate regulatory arbitrage that encourages the migration of activities from the traditional regulated markets into the differently regulated swaps markets. The SEC asked Congress to modify the draft so that all securities-related OTC derivatives are regulated more like securities, and commodity and other non-securities-related OTC derivatives are regulated more like futures.

The SEC's concern is compounded by the fact that the draft revises the Securities Act to include security-based swaps in the definition of "security" but does not make the corresponding change in the Exchange Act. The SEC urged Congress make the additional change because including security-based swaps in the Exchange Act is necessary to reduce regulatory arbitrage and provide Rule 10b-5 antifraud protections for these markets.

Provisions in the draft calling for the SEC to adopt business-conduct rules do not fill the gap because the rules would relate only to the conduct of security-based swap dealers and major security-based swap participants and would not reach brokers who sell security-based swaps to retail investors. Such brokers would not have to register with the SEC or become FINRA members. Including security-based swaps in the Exchange Act would also give the SEC the tools to oversee the exchange trading of such instruments.

Similarly, inter-dealer brokers would remain outside the regulatory framework, said the SEC, and they are important players in the OTC derivatives markets, as most credit default swaps are done through such brokers. Adding security-based swaps to the definition of "security" would ensure that the SEC can oversee these players.

The draft contains an abusive-swap provision, which allows the SEC and the CFTC to jointly prohibit swap transactions detrimental to market stability or to market participants. This could be a useful regulatory tool, said the SEC, but Congress should consider how regulators would quantify the destabilizing effects of the derivatives and balance the tension between the destabilizing effects on the entire financial system and large individual participants and make determinations for products that are both useful and potentially destabilizing. There must be a process for making this determination because other regulators might not agree with a decision and because there could be a conflict between the SEC and the CFTC. Congress may want to consider giving this authority to the Financial Stability Oversight Council instead of to the SEC and CFTC.

Because regulation of major swap participants and dealers is vital to the new OTC regulatory regime, Congress must take care not to allow entities using swaps as risk management tools to fall outside the scheme. The Treasury draft defined a "major security-based swap participant" as any non-dealer maintaining a substantial net position in outstanding swaps for purposes other than to create and maintain an effective hedge under GAAP. The House draft is broader and excludes those holding positions for risk management purposes. The SEC said that the term "risk management" is ambiguous, and its use could cause many important entities to fall outside the new regulation. The SEC urged Congress to adopt a more narrow and objective standard more consistent with the legislative purpose.

According to the SEC, the draft also has an overly broad definition of "swap" that could include products and transactions already subject to federal and state securities regulation, including investment contracts, some stock options, and security forwards. The SEC sees no benefit in including instruments already subject to the full panoply of securities regulation in the definition and urged Congress to clarify that such products or transactions do not fall within it.

The draft's exclusion of identified banking products from OTC-derivatives regulation could allow foreign banks not subject to oversight by a federal banking regulator to offer derivatives products in the United States under the guise of offering banking products. Congress was urged to clarify that the exclusion is not available to foreign banks that are not subject to federal banking regulation.

The draft would create a new category of mixed swaps where dual SEC-CFTC regulation would apply to swaps that are both securities- and non-securities based. The SEC is concerned that even quintessentially security-based swaps could be deemed mixed swaps under this rubric. For example, a market player entering into an equity swap with a synthetic substitute for owning the shares will often have to make either fixed- or floating-rate interest payments to the derivatives dealer providing the swap. Under the draft's proposed definition of "mixed swap," the mere use of a floating basis for interest rate payments could cause the swap to be a mixed swap subject to joint SEC-CFTC oversight. The SEC urged Congress to clarify that a swap is not considered a mixed swap merely because it has a floating-interest-rate component or a foreign-currency component.

The SEC fears that the draft would establish a joint rulemaking process with the CFTC that would be hard to implement. The draft places important definitions of security-based swaps within the Commodity Exchange Act. This would establish a rulemaking process undercutting the SEC's ability to interpret terms in response to market and regulatory developments. If Congress insists on using joint rulemaking, said the director, it should put all definitions in the text of the legislation itself with cross references to the securities and commodities laws.

The financial crisis demonstrated that less-sophisticated institutions need protection from abusive practices by their swap intermediaries through improved business conduct standards. As such, the Treasury draft would require the SEC and the CFTC to adopt business conduct rules for dealers and major participants in the OTC derivatives markets. Congress should also direct the commissions to adopt more protective rules when a swaps dealer is selling OTC derivatives to the less sophisticated.

Also, the SEC stated that Congress should revise the qualification standards for participation in the OTC-derivatives markets, The standards for being an eligible contract participant under the Treasury draft are important because only such participants may trade OTC derivatives. All other participants must trade on exchanges. Thus, the SEC urged Congress to raise the qualification standards for a governmental entity, such as a municipality, to qualify as an eligible contract participant.

Currently, the SEC believes that exchange-traded credit default swaps on securities are securities whether involving one security or a basket of securities. In order to reduce the opportunity for regulatory arbitrage, Congress was asked to clarify that the definition of “security-based swap” includes broad-based index credit default swaps as well as single-name and narrow-based index credit default swaps.