Senate Banking Discusses Derivatives Reform with SEC and CFTC Chairmen
AT TODAY’S SENATE BANKING COMMITTEE HEARING, lawmakers heard from Securities and Exchange Commission (SEC) Chairman Mary Schapiro and Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler on the implementation of derivatives regulation under the Dodd-Frank Act.
In his opening statement, Chairman Tim Johnson (D-S.D.) called for full funding for the regulatory agencies to ensure that there are “cops on the beat” and praised the benefits derivatives reform will have on reducing risk in the financial system.
In his opening statement , Ranking Member Richard Shelby (R-Ala.) referenced the bankruptcy of MF Global and criticized the failure of the CFTC to adequately protect customer funds. He pointed out Gensler’s recusal from the matter and stated his hope for the Chairman to become more involved with the issue so that “Congress can finally begin to understand what role he played and how Congress should respond.” Shelby also criticized the pace with which both the CFTC and SEC have been implementing Dodd-Frank rulemakings, specifically pointing to the fact that the agencies have yet to finalize product definition rules and questioning how firms are expected to comply with registration requirements without knowing what activities will be subject to those requirements.
Testimony
In her opening statement, Schapiro provided an overview of the SEC’s efforts to implement Title VII of Dodd-Frank. Schapiro noted that the SEC plans to complete the last of the proposal phase in the near term and to finalize the joint product definitions rules in the “very near term.” She said the SEC’s cross-border release will be addressed in a single proposal.
In his opening statement, Gensler provided an overview of the CFTC’s Title VII implementation efforts and discussed the agency’s pending work. With regard to the cross-border release, Gensler said the CFTC staff will soon be recommending the Commission publish the proposal for comment. He said key elements of the rule are likely to include:
- When a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity, the entity would register under the CFTC’s recently completed swap dealer registration rules;
- The release will address what it means to be a U.S. facing transaction. Gensler said he believes this must include transactions not only with persons or entities operating in the United States, but also with their overseas branches;
- A tiered approach for requirements for overseas swap dealers. Entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance; and
- Transaction-level requirements would apply to all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply.
Question and Answer
Johnson began the hearing by asking about the role of the CFTC and SEC in monitoring the swaps trades at issue in the JPMorgan matter.
Gensler said the credit default swap (CDS) indices that were part of the trading matter fall under the agency’s anti-fraud and anti-manipulation regime. He noted that the CFTC will seek comment on a clearing mandate so that more trades will come into a clearinghouse. He also noted that the bank has not yet registered as a swap dealer because the rules to complete the process are not yet finalized.
Schapiro noted that the transactions were not held or executed in the U.S. broker-dealer but took place in the London branch which is regulated by the Office of the Comptroller of the Currency (OCC).
Johnson asked Schapiro if the SEC can commit to issuing the last of the proposed derivatives-related rulemakings in the coming months.
Schapiro affirmed the SEC’s ability to make such a commitment and noted that the agency will seek comment on an implementation and sequencing plan. She also said the SEC will propose a cross-border release that will address the extraterritorial application of Dodd-Frank and will propose the release “before we adopt final rules beyond the definitional rules.”
Volcker Rule
Sen. Robert Menendez (D-N.J.) asked if the agencies hope to interpret the Volcker Rule “in a way that what took place at JPMorgan would not have been possible to have taken place or would have taken place without real consequences.”
Schapiro said the Volcker Rule is “foremost in everyone’s minds because of where we are in the process of reviewing comment letters but also because of this activity.” She noted how the statute is clear about the criteria that must be met to qualify for a risk-mitigating hedging exemption and said the agencies do not have a view yet on whether the firm’s trades would meet such an exemption.
“The compensation of the persons doing the trading cannot contribute to their taking out-size risk or unnecessary risk. And they have to, importantly I think, document the risk-mitigating purpose of the trades when the hedge is being done at a desk that’s different than the position that’s being hedged was done at. So I think there’s strong language there, and what we need to do is take what happened at JPMorgan and view it through the lens of these criteria and see how that helps to inform the rulemaking going forward,” Schapiro said.
Sen. Bob Corker (R-Tenn.) stated his concern that when “an event like the one that’s just occurred” happens in the middle of a rulemaking process the rules become affected. He asked if the Volcker Rule will then turn into “something that it was never intended to be.”
Gensler said that the recent events were “just a reminder in one area” and that he looks at the events more in the context of the cross-border application of rules than the Volcker Rule.
Sen. Jeff Merkley (D-Ore.) referred to the liquidity management provision in the Volcker Rule in the context of JPMorgan’s trading loss and asked where the appropriate place would be to “put your funds in between making loans so that you are clearly in the deposit-taking, loan-making business and not in the hedge fund business.”
Schapiro said the rationale behind the liquidity management exclusion was to make sure banks had sufficient assets to meet their short-term liquidity needs. She noted that Merkley’s question requires the agencies to see if the provision was carried to its “logical extreme” and “whether we need to tighten this up and just look at it much more closely and much more carefully.”
Merkley discussed how a firm that has funds in between making loans under the Volcker Rule’s liquidity provision and chooses to transact in corporate bonds can lead to a domino effect in terms of taking on more hedging positions. He asked whether regulators have drawn the line from risk mitigation to “simply having an excuse to do hedge-fund style trading.”
Schapiro acknowledged that there is a “long continuum to something like portfolio hedging” and that finding that point will be difficult. She said the metrics are designed to help regulators with this challenge. “I don’t think there’s an expectation that all of those [metrics] will make it into the final rule. But the goal there is to help us see how behavior changes over time within a firm — how transactions change over time — as a way to see whether things that are hedging are moving into a different realm,” Schapiro said.
Merkley asked if it would be a red flag if a firm is buying insurance to insure a larger quantity than the firm is actually holding.
Schapiro agreed that such a situation is a red flag and said positions that are being hedged must demonstrate that the hedge is risk reducing.
Gensler added that the word “reasonably” in the term “reasonably correlated” with regard to the hedging exemption may need to be further defined.
Sen. Jack Reed (D-R.I.) noted the “tension” between risk management and profit making with regard to the Volcker Rule and asked how the agencies are dealing with this.
Schapiro stated the agency’s belief that businesses have the ability to engage in market making and to appropriately hedge risk. She said the criteria is good in helping regulators “keep the focus on hedging as truly hedging” with regard to mitigating specific risk on an individual or aggregated position and not having the hedge itself give risk to significant exposures. She said it is incumbent upon regulators to write a rule that “allows legitimate hedging to go forward as it needs to, but it must be really, genuinely risk-mitigating hedging and not anything people want to do called hedging.”
Gensler added to Schapiro’s response by noting that the concept of portfolio hedging can mean different things to different people. Gensler said that from his experience, “things morph into something else…particularly when they are set up as a separate business unit, and they have a separate profit-and-loss statement and separate compensation.”
Sen. Pat Toomey (R-Pa.) followed up on the portfolio hedging discussion and asked whether it will be permissible and cost effective to manage interest rate, currency, and credit risks in the aggregate in these portfolios rather than limiting it to a one-off individual basis, and whether the rules prescribe the kinds of instruments that would be permissible to use to hedge these portfolios.
Gensler said the rules as written refer to instruments that are “reasonably” correlated with the risks, but noted that it may change in the final rule.
Toomey referenced the myriad issues the Volcker Rule attempts to address and cautioned that micromanaging firms may result in “staggering” costs of compliance for firms as well as reduced liquidity. He said the better solution is to require more capital and “let the people in the marketplace make the decisions they will make and then let them live with the consequences without having the taxpayer at risk…”
Extraterritoriality
Sen. Mike Johanns (R-Neb.) noted the possibility of regulators imposing too stringent rules that will incentivize firms to move their operations out of the U.S. and asked if firms can already structure their businesses to avoid U.S. regulation.
Schapiro said the agency is grappling with such issues with its cross-border application release. With regard to this release, she stated that “generally a foreign entity with a foreign customer, we can feel reasonably comfortable that our Title VII rules wouldn’t apply…a foreign entity that’s registered with us doing business with a foreign customer would likely be subject to our rules.”
“A U.S. entity, including a branch of the U.S. entity operating in a different country or doing business with any U.S. person, would have Title VII rules applying. So we want to lay this out in detail for commenters,” she added.
Johanns also asked about the ability of regulators to harmonize reform efforts on a global scale.
Gensler said there would be differences in regulation globally but that the costs of not imposing sufficient rules and potentially putting taxpayers at risk was “too great.” He said the agencies are appropriately trying to construct a cross-border application of the rules where there is a direct and significant effect on U.S. commerce. He said the agencies will not be “as good as we hope to be” and that “they will get something by us — and probably three to six years or 10 years somebody will say, you missed — they figured out something in the Mauritius Islands or something.”
Data Collection, FSOC
Sen. Kay Hagan (D-N.C.) asked when the SEC will implement its data collection efforts.
Schapiro said the security-based swap reporting data collection will begin “hopefully sometime later this year.”
Gensler added that the CFTC will have reporting rules in the CDS indice area and in interest rates “as soon as August” and then three months after that with regard to commodities.
Sen. Mark Warner (D-Va.) asked about the efficacy of the Financial Stability Oversight Council (FSOC) in acting as the adjudicator with regard to any disputes between the agencies.
Both Schapiro and Gensler said the FSOC has been an effective forum for regulators to discuss issues. Gensler noted that the FSOC has not yet been tested under a crisis situation and has not had to arbitrate any substantial disputes between the agencies.
For testimony and a webcast of the hearing, please click here.
,Blog Tags:,Blog Categories:,Blog TrackBack:,Blog Pingback:No,Hearing Summaries Issues:Derivatives,Hearing Summaries Agency:Senate Banking Committee,Publish Year:2012
AT TODAY’S SENATE BANKING COMMITTEE HEARING, lawmakers heard from Securities and Exchange Commission (SEC) Chairman Mary Schapiro and Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler on the implementation of derivatives regulation under the Dodd-Frank Act.
In his opening statement, Chairman Tim Johnson (D-S.D.) called for full funding for the regulatory agencies to ensure that there are “cops on the beat” and praised the benefits derivatives reform will have on reducing risk in the financial system.
In his opening statement , Ranking Member Richard Shelby (R-Ala.) referenced the bankruptcy of MF Global and criticized the failure of the CFTC to adequately protect customer funds. He pointed out Gensler’s recusal from the matter and stated his hope for the Chairman to become more involved with the issue so that “Congress can finally begin to understand what role he played and how Congress should respond.” Shelby also criticized the pace with which both the CFTC and SEC have been implementing Dodd-Frank rulemakings, specifically pointing to the fact that the agencies have yet to finalize product definition rules and questioning how firms are expected to comply with registration requirements without knowing what activities will be subject to those requirements.
Testimony
In her opening statement, Schapiro provided an overview of the SEC’s efforts to implement Title VII of Dodd-Frank. Schapiro noted that the SEC plans to complete the last of the proposal phase in the near term and to finalize the joint product definitions rules in the “very near term.” She said the SEC’s cross-border release will be addressed in a single proposal.
In his opening statement, Gensler provided an overview of the CFTC’s Title VII implementation efforts and discussed the agency’s pending work. With regard to the cross-border release, Gensler said the CFTC staff will soon be recommending the Commission publish the proposal for comment. He said key elements of the rule are likely to include:
- When a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity, the entity would register under the CFTC’s recently completed swap dealer registration rules;
- The release will address what it means to be a U.S. facing transaction. Gensler said he believes this must include transactions not only with persons or entities operating in the United States, but also with their overseas branches;
- A tiered approach for requirements for overseas swap dealers. Entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance; and
- Transaction-level requirements would apply to all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply.
Question and Answer
Johnson began the hearing by asking about the role of the CFTC and SEC in monitoring the swaps trades at issue in the JPMorgan matter.
Gensler said the credit default swap (CDS) indices that were part of the trading matter fall under the agency’s anti-fraud and anti-manipulation regime. He noted that the CFTC will seek comment on a clearing mandate so that more trades will come into a clearinghouse. He also noted that the bank has not yet registered as a swap dealer because the rules to complete the process are not yet finalized.
Schapiro noted that the transactions were not held or executed in the U.S. broker-dealer but took place in the London branch which is regulated by the Office of the Comptroller of the Currency (OCC).
Johnson asked Schapiro if the SEC can commit to issuing the last of the proposed derivatives-related rulemakings in the coming months.
Schapiro affirmed the SEC’s ability to make such a commitment and noted that the agency will seek comment on an implementation and sequencing plan. She also said the SEC will propose a cross-border release that will address the extraterritorial application of Dodd-Frank and will propose the release “before we adopt final rules beyond the definitional rules.”
Volcker Rule
Sen. Robert Menendez (D-N.J.) asked if the agencies hope to interpret the Volcker Rule “in a way that what took place at JPMorgan would not have been possible to have taken place or would have taken place without real consequences.”
Schapiro said the Volcker Rule is “foremost in everyone’s minds because of where we are in the process of reviewing comment letters but also because of this activity.” She noted how the statute is clear about the criteria that must be met to qualify for a risk-mitigating hedging exemption and said the agencies do not have a view yet on whether the firm’s trades would meet such an exemption.
“The compensation of the persons doing the trading cannot contribute to their taking out-size risk or unnecessary risk. And they have to, importantly I think, document the risk-mitigating purpose of the trades when the hedge is being done at a desk that’s different than the position that’s being hedged was done at. So I think there’s strong language there, and what we need to do is take what happened at JPMorgan and view it through the lens of these criteria and see how that helps to inform the rulemaking going forward,” Schapiro said.
Sen. Bob Corker (R-Tenn.) stated his concern that when “an event like the one that’s just occurred” happens in the middle of a rulemaking process the rules become affected. He asked if the Volcker Rule will then turn into “something that it was never intended to be.”
Gensler said that the recent events were “just a reminder in one area” and that he looks at the events more in the context of the cross-border application of rules than the Volcker Rule.
Sen. Jeff Merkley (D-Ore.) referred to the liquidity management provision in the Volcker Rule in the context of JPMorgan’s trading loss and asked where the appropriate place would be to “put your funds in between making loans so that you are clearly in the deposit-taking, loan-making business and not in the hedge fund business.”
Schapiro said the rationale behind the liquidity management exclusion was to make sure banks had sufficient assets to meet their short-term liquidity needs. She noted that Merkley’s question requires the agencies to see if the provision was carried to its “logical extreme” and “whether we need to tighten this up and just look at it much more closely and much more carefully.”
Merkley discussed how a firm that has funds in between making loans under the Volcker Rule’s liquidity provision and chooses to transact in corporate bonds can lead to a domino effect in terms of taking on more hedging positions. He asked whether regulators have drawn the line from risk mitigation to “simply having an excuse to do hedge-fund style trading.”
Schapiro acknowledged that there is a “long continuum to something like portfolio hedging” and that finding that point will be difficult. She said the metrics are designed to help regulators with this challenge. “I don’t think there’s an expectation that all of those [metrics] will make it into the final rule. But the goal there is to help us see how behavior changes over time within a firm — how transactions change over time — as a way to see whether things that are hedging are moving into a different realm,” Schapiro said.
Merkley asked if it would be a red flag if a firm is buying insurance to insure a larger quantity than the firm is actually holding.
Schapiro agreed that such a situation is a red flag and said positions that are being hedged must demonstrate that the hedge is risk reducing.
Gensler added that the word “reasonably” in the term “reasonably correlated” with regard to the hedging exemption may need to be further defined.
Sen. Jack Reed (D-R.I.) noted the “tension” between risk management and profit making with regard to the Volcker Rule and asked how the agencies are dealing with this.
Schapiro stated the agency’s belief that businesses have the ability to engage in market making and to appropriately hedge risk. She said the criteria is good in helping regulators “keep the focus on hedging as truly hedging” with regard to mitigating specific risk on an individual or aggregated position and not having the hedge itself give risk to significant exposures. She said it is incumbent upon regulators to write a rule that “allows legitimate hedging to go forward as it needs to, but it must be really, genuinely risk-mitigating hedging and not anything people want to do called hedging.”
Gensler added to Schapiro’s response by noting that the concept of portfolio hedging can mean different things to different people. Gensler said that from his experience, “things morph into something else…particularly when they are set up as a separate business unit, and they have a separate profit-and-loss statement and separate compensation.”
Sen. Pat Toomey (R-Pa.) followed up on the portfolio hedging discussion and asked whether it will be permissible and cost effective to manage interest rate, currency, and credit risks in the aggregate in these portfolios rather than limiting it to a one-off individual basis, and whether the rules prescribe the kinds of instruments that would be permissible to use to hedge these portfolios.
Gensler said the rules as written refer to instruments that are “reasonably” correlated with the risks, but noted that it may change in the final rule.
Toomey referenced the myriad issues the Volcker Rule attempts to address and cautioned that micromanaging firms may result in “staggering” costs of compliance for firms as well as reduced liquidity. He said the better solution is to require more capital and “let the people in the marketplace make the decisions they will make and then let them live with the consequences without having the taxpayer at risk…”
Extraterritoriality
Sen. Mike Johanns (R-Neb.) noted the possibility of regulators imposing too stringent rules that will incentivize firms to move their operations out of the U.S. and asked if firms can already structure their businesses to avoid U.S. regulation.
Schapiro said the agency is grappling with such issues with its cross-border application release. With regard to this release, she stated that “generally a foreign entity with a foreign customer, we can feel reasonably comfortable that our Title VII rules wouldn’t apply…a foreign entity that’s registered with us doing business with a foreign customer would likely be subject to our rules.”
“A U.S. entity, including a branch of the U.S. entity operating in a different country or doing business with any U.S. person, would have Title VII rules applying. So we want to lay this out in detail for commenters,” she added.
Johanns also asked about the ability of regulators to harmonize reform efforts on a global scale.
Gensler said there would be differences in regulation globally but that the costs of not imposing sufficient rules and potentially putting taxpayers at risk was “too great.” He said the agencies are appropriately trying to construct a cross-border application of the rules where there is a direct and significant effect on U.S. commerce. He said the agencies will not be “as good as we hope to be” and that “they will get something by us — and probably three to six years or 10 years somebody will say, you missed — they figured out something in the Mauritius Islands or something.”
Data Collection, FSOC
Sen. Kay Hagan (D-N.C.) asked when the SEC will implement its data collection efforts.
Schapiro said the security-based swap reporting data collection will begin “hopefully sometime later this year.”
Gensler added that the CFTC will have reporting rules in the CDS indice area and in interest rates “as soon as August” and then three months after that with regard to commodities.
Sen. Mark Warner (D-Va.) asked about the efficacy of the Financial Stability Oversight Council (FSOC) in acting as the adjudicator with regard to any disputes between the agencies.
Both Schapiro and Gensler said the FSOC has been an effective forum for regulators to discuss issues. Gensler noted that the FSOC has not yet been tested under a crisis situation and has not had to arbitrate any substantial disputes between the agencies.
For testimony and a webcast of the hearing, please click here.