Back to the Drawing Board on Derivatives Regulation

U.S. House Financial Services Committee Chairman Barney Frank (D-MA) distributed a proposal for derivatives regulation this week and it was the subject of a hearing by the committee yesterday.  A major part of the discussion centered on a potential loophole that would allow many corporations, if not all, to avoid the new regulation altogether. Here is what Bloomberg.com reported about the hearing and draft legislation prepared by Chairman Frank.

A plan offered by the Obama administration would subject all swaps dealers and “major market participants” to new regulations for capital, business conduct, record-keeping and reporting. Frank’s version would exempt corporations from that definition if they use derivatives for “risk management” purposes.

While Frank’s proposal is a “step in the right direction,” its “ambiguous” definition of risk management may leave a large number of corporations unregulated, Henry T.C. Hu, director of the SEC’s new division of risk, strategy and financial innovation, told the committee.

“As just about all swaps could be defined as being used for risk management purposes, we’re concerned that unintentionally the category of ‘major swap participant’ could have been narrowed so significantly, or even to a null set,” CFTC Chairman Gary Gensler told reporters after the hearing.

“Major hedge funds” may be excluded from oversight, as may the mortgage-finance companies Fannie Mae and Freddie Mac “because of course the government-supported enterprises use swaps for risk management purposes,” Gensler said.

It looks like Chairman Frank may need to re-educate himself on the use of derivatives and go back to the drawing board on this proposal.

Regulating Financial Weapons of Mass Destruction

The Obama Administration unveiled its proposed regulatory legislation for derivatives yesterday.  This legislation is the centerpiece of the financial regulatory overhaul due to the role derivatives played in the recent economic meltdown.  The new legislation to be considered by Congress aims to prevent future abuse of derivatives and, as a result, decrease the systemic risks posed by these markets.  Here is a summary of the goals of the legislation.

As part of the Administration's proposed legislation, credit default swap markets and all other OTC derivative markets will be subject to comprehensive regulation in order to:

1. Guard against activities in those markets posing excessive risk to the financial system


2. Promote the transparency and efficiency of those markets


3. Prevent market manipulation, fraud, insider trading, and other market abuses


4. Block OTC derivatives from being marketed inappropriately to unsophisticated parties

These goals will be reached through comprehensive regulation that includes:

1. Regulation of OTC derivative markets


2. Regulation of all OTC Derivative dealers and other major market participants


3. Preventing market manipulation, fraud, insider trading, and other market abuses


4. Protecting unsophisticated investors

While the goals are clear, the methods to regulate are less so.  Responsibility for enforcement of the new regulations will be assigned to multiple agencies and may over time prove to be less than effective.  Warren Buffett famously described derivatives as "financial weapons of mass destruction".  Given the size and magnitude of the markets to be regulated, the accountability for enforcement should be strengthened to ensure proper oversight of these potentially deadly securities.