By Robert Hunter

The sun has finally set on Brooksley Born's dominion over the Commodity Futures Trading Commission. Last November, the President's Working Group on Financial Markets, consisting of regulators from the Treasury Department, the Federal Reserve, the SEC and the CFTC, issued its long-awaited report on over-the-counter derivatives regulation.

In one breathtaking sweep, the commission cleared away the legal uncertainty for swaps and outlined an updated regulatory framework that addresses new advances in electronic trading and clearing systems.

The commission's most important goal, it seems, was to restore the legal certainty to the OTC markets that Born had whittled away during her tenure as chairwoman. The commission was particularly concerned that uncertainty over OTC derivatives had hampered private-sector efforts to create electronic trading systems and clearing facilities.

The result: a series of amendments to the Commodity Exchange Act, which governs the use of swaps and other financial instruments.

It proposed that bilateral swaps entered into on a principal-to-principal basis should be excluded from the CEA entirely, and thus exempt from regulation, provided the transactions are not conducted on a "multilateral transaction execution facility.” (The report deals with electronic trading and clearing systems separately.) The exclusion would not apply to nonfinancial commodities with a finite supply, such as gold, and would apply only to financial institutions and wealthy individuals that met certain criteria.

The report was also eager to promote electronic trading systems for OTC derivatives and remove the specter of regulation in order to allow them to grow to their full potential. It argued that the systems could improve efficiency and transparency, reduce risks by improving liquidity, and allow firms to create better internal controls on their traders.

The group argued that electronic brokerages and auction sites, which don't directly execute transactions, should be excluded from CEA regulation. Moreover, futures exchanges that fall under CFTC regulation should be permitted to establish these types of trading systems for qualified swaps, with the same regulatory treatment as is given to OTC trading sites.

The report was careful to point out that these recommendations did not mean that these systems should never be regulated. If electronic trading systems for OTC derivatives grow, the CFTC would probably be the appropriate regulator. At this point in time, however, "it is better to encourage the development of these systems by providing greater legal certainty than to attempt to anticipate an appropriate regulatory scheme for market innovations that are still in the initial stages of development and implementation,” the report noted.

The group was also eager to promote clearing systems as another market cure-all. It argued that OTC clearinghouses could reduce counterparty risk by mutualizing risks, facilitating offset and netting contracts, and urged Congress to allow CFTC- and SEC-regulated clearing organizations to clear OTC derivatives. All other OTC clearing systems would be required to organize as banking institutions regulated by the Federal Reserve or the Office of the Comptroller of the Currency.

The report acknowledged that liberalizing the regulatory structure for derivatives could probably serve to blur the distinctions between swaps and futures and create an unfair regulatory burden for futures market participants and exchanges. The group pointed out, however, that futures exchanges could enter the OTC markets as exchanges, clearinghouse or both, which could help fix the imbalance. It also pointed out that listed futures markets deserve more regulation than OTC markets, because of the presence of retail investors.

The group tackled the thorny issue of how to regulate hybrid instruments as well. The CEA gives the CFTC exclusive jurisdiction over commodity futures and options on futures. This has created some legal uncertainty as to the appropriate regulator for complex derivatives that have elements of securities and futures contracts. The report recommended that other regulators be granted jurisdiction when parts of a hybrid instrument fall within their regulatory net.

The group was reluctant to wade into the highly contentious issue of regulating single-stock futures. The report noted that "the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved.” The operative word here is "if.” Since the SEC regulates the securities industry and the CFTC regulates the futures industry, the group's tepid proposal is for the agencies to "work together and with Congress to determine whether the trading of single-stock futures should be permitted, and if so, under what conditions.”

Congress Attacks Hedge Fund Report

Last April, when the President's Working Group on Financial Markets issued "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” it seemed likely to be the regulatory world's last word on the LTCM disaster, complete with recommendations to minimize the risks of hedge funds on the U.S. financial system. In November, however, the Government Accounting Office unleashed a scathing critique of the report, and moments later two Democratic congressmen proposed new legislation based on the GAO's recommendations. The GAO report was unremittingly critical. "LTCM's crisis showed that the traditional focus of federal financial regulators on individual institutions and markets is not adequate to identify potential systemic threats that cross these institutions and markets,” it reads. "Although market participants have the primary responsibility to practice prudent risk management standards, prudent standards do not guarantee prudent practices.” Using the GAO report as ammunition, Rep. Edward Markey (D-Mass.) and Sen. Byron Dorgan (D-N.D.) proposed the Derivatives Market Reform Act, which would require the SEC to regulate derivatives firms that aren't affiliated with banks and to institute large-trader reporting rules. It would also require the SEC and bank regulators to report annually on their success in achieving interagency cooperation. Hedge funds, meanwhile, would have to issue quarterly reports on their financial condition and their risk management techniques. "We should not have to wait until the next hedge fund meltdown to take prudent measures to enhance the stability of our markets and our financial regulatory systems,” says Markey. "We are not calling for the banning of any practices or technologies. We are asking for more transparency in trading practices, and, where necessary, for information to be given to regulators so that they know and understand what is happening in the marketplace at all times.” "The report shows that no one was watching the store and the taxpayers were put at risk,” says Dorgan. "We want to make sure it never happens again.” The GAO identified a number of failings in both the LTCM disaster and in the President's Working Group report. It argued that market discipline, the invisible hand that is supposed to prevent market abuses, did not prevent LTCM from building up large, leveraged trading positions and creating potential systemic risk. Regulators, meanwhile, did not identify the threat posed by LTCM and did not identify the weaknesses in firms' risk management practices until after the crisis. It said that a gap in the regulatory authority of the SEC and CFTC limits their ability to identify and mitigate systemic risk, and that both agencies lack the authority to regulate affiliates of broker-dealers and future commission merchants. It argued that the President's Working Group's proposed expansion of SEC and CFTC authority over the activities of affiliates of broker-dealers and FCMs would not close the regulatory gap, because regulators would not be able to perform comprehensive examinations, set capital standards or take general enforcement actions. The report argues that the blurring in recent years of the traditional lines separating banks, securities brokers and FCMs makes it more important than ever for regulators to get hold of information that cuts across those lines. "Regulators for each industry have generally continued to focus on individual firms and markets, the risks they face and the soundness of their practices, but they have failed to address interrelationships across each industry,” reads the report. "The risks posed by LTCM crossed traditional regulatory and industry boundaries, and the regulators would have needed to coordinate their activities to have had a chance of identifying these risks. Although regulators have recommended improvements to information reporting requirements, they have not recommended ways to better identify risks across markets and industries.” Its recommendation: that regulators develop better ways to coordinate oversight activities that cross traditional regulatory and industry boundaries, including the ability to regulate the activities of securities and futures firms' affiliates, much like the Federal Reserve has authority over bank holding companies. This authority, argues the GAO, should include the ability to examine, set capital standards and take enforcement actions.

—R.H.