Bringing transparency and
accountability to derivatives
The Banking Committee’s summary
of the bill sets out the rationale for tightening derivatives
regulation. It highlights how the OTC market "has exploded
– from $91tr in 1998 to $592tr in 2008", and how
during the financial crisis, "concerns about the ability of
companies to make good on these contracts and the lack of
transparency about what risks existed caused credit markets to
"Over-the-counter derivatives are supposed
to be contracts that protect businesses from risks, but they
became a way for traders to make enormous bets with no
regulatory oversight or rules and therefore exacerbated risks,"
the summary says. "Because the derivatives market was
considered too big and too interconnected to fail, taxpayers
had to foot the bill for Wall Street’s bad bets.
Those bad bets linked thousands of traders, creating a web in
which one default threatened to produce a chain of corporate
and economic failures worldwide. These interconnected trades,
coupled with the lack of transparency about who held what, made
unwinding the 'too big to fail’ institutions more
costly to taxpayers."
The bill’s measures
· Closing regulatory
gaps The bill authorises the SEC and CFTC to regulate
over-the-counter OTC derivatives so that irresponsible
practices and excessive risk-taking cannot escape regulatory
oversight. It uses the administration’s outline
for a joint rulemaking process with the Financial Stability
Oversight Council stepping in if the two agencies cannot
· Central clearing and
exchange trading Central clearing and exchange trading
would be required for derivatives that can be cleared. Both
regulators and clearing houses would have a role in determining
which contracts should be cleared. The SEC and CFTC must
pre-approve contracts before clearing houses can clear
· Safeguards for uncleared
trades Firms would have to post
margin for uncleared trades to offset the
greater risk they pose to the financial system and to encourage
more trading to take place in transparent, regulated markets.
Swap dealers and major swap participants will be subject to
transparency: All trades must be reported to clearing
houses or swap repositories to improve market transparency and
help regulators monitor and respond to risks.
An important proposal is to create a nine member Financial
Stability Oversight Council, chaired by the Treasury secretary,
and including the heads of the US Securities and Exchange
Commission and Commodity Futures Trading Commission.
This will be able to recommend to the
Federal Reserve increasingly strict rules for capital,
leverage, liquidity, risk management and other requirements as
companies grow in size and complexity, especially for those
that pose systemic risk.
With a two-thirds majority, the council will
be authorised to require that a non-bank financial company of
systemic importance be regulated by the Federal Reserve
– or to break up a large company if it posed "a grave
threat to the financial stability of the United States".
A new Office of Financial Research at the
Treasury would support the council’s work by
collecting financial data and conducting economic analysis. In
particular, it will strive to make emerging risks to the
The council would also identify systemically
important clearing, payments, and settlements systems to be
regulated by the Federal Reserve.
Pay and corporate
The bill addresses weaknesses in US
corporate governance and perceptions that executive pay schemes
have contributed to the financial crisis. "In this country, you
are supposed to be rewarded for hard work," says the Banking
Committee’s summary of the bill. "But Wall Street
has developed an out of control system of out of this world
bonuses that rewards short term profits over the long term
health and security of their firms."
Shareholders would gain the right to a
non-binding vote on executive pay and more powers to nominate
and vote on directors. Listed companies will have to publish
charts comparing their executive pay with share price
performance over five years.
Beefing up the SEC and investor
The bill tackles the SEC’s
failures in the financial crisis, such as not stopping the
Bernard Madoff fraud.
Whistleblowers will be encouraged with
rewards of up to 30% of funds recovered. There will be an
annual assessment of the SEC’s internal
supervisory controls and a Government Accountability Office
study of its management.
The bill would require a study on whether
brokers who give investment advice should be held to the same
fiduciary standard as investment advisers – that they
act in their clients’ best interest.
It would create an Investment Advisory
Committee, a committee of investors to advise the SEC on its
regulatory priorities and practices, as well as an Office of
Investor Advocate in the SEC, to identify areas where investors
have significant problems dealing with the SEC and provide them
The self-funded SEC will also no longer be
subject to the annual Congress appropriations process.
The bill addresses the lack of information
available to regulators about the huge hedge fund sector.
Hedge funds that manage over $100m will be
required to register with the SEC as investment advisers and
provide information about their trades and portfolios necessary
to assess systemic risk and protect investors.
The bill would raise the assets threshold
for federal regulation of investment advisers from $25m to
$100m, increasing by 28% the number of advisers supervised at
the state level.
"States have proven to be strong regulators
in this area," the bill’s sponsors believe, "and
subjecting more entities to state supervision will allow the
SEC to focus its resources on newly registered hedge
Ending too big to fail bailouts
Extensive rules are planned that are
designed to ensure taxpayers do not have to bail out financial
firms and to address the moral hazard problem that the bailouts
of the past two years have created.
Besides discouraging "excessive growth and
complexity" by setting progressive capital and liquidity rules
that are tougher for bigger and more complex companies, the
Financial Stability Oversight Council will be charged to make a
study on the so-called Volcker Rule, proposed by former Fed
chairman Paul Volcker.
This would require regulators to ban banks
from proprietary trading, investment in and sponsorship of
hedge funds and private equity funds, and to limit
banks’ relationships with hedge funds and private
equity funds. The Council would develop such regulations after
Big financial firms will also have to submit
"funeral plans" – known in the UK as "living wills"
– showing regulators how they could be easily shut
down if they failed. Penalty costs for failing to produce a
credible plan would create incentives for firms to clean up
structures that could not be unwound easily.
The bill would create an orderly liquidation
mechanism for the Federal Deposit Insurance Corporation to
unwind failing systemically significant financial companies.
Shareholders and unsecured creditors would bear the losses and
management would be removed.
The Treasury, FDIC and Federal Reserve would
all have to agree to put a company into the orderly liquidation
process. A panel of three bankruptcy judges would have to
convene and agree within 24 hours that a company was
A levy on the largest financial firms, over
time, would harvest $50bn to fill an upfront fund to be used if
needed for any liquidation. The intention is that the financial
industry, not taxpayers, would take a hit for liquidating
large, interconnected financial companies.
The FDIC would be allowed to borrow from the
Treasury only for working capital that it expected to be repaid
from the assets of the company being liquidated. The government
would be first in line for repayment.
The bill updates the Federal
Reserve’s 13(3) emergency lending authority to
prohibit emergency lending to an individual entity. The
Treasury secretary must approve any lending programme, and such
programmes must be broad and not aid a failing financial
company. Collateral must be sufficient to protect taxpayers
Most large financial companies are expected
to be resolved through the bankruptcy process.
To prevent bank runs, the FDIC can guarantee
the debt of solvent insured banks, but only if top officials
right up to the President agree.
Improving bank regulation
The bill aims to streamline the present
system of four banking regulators, to reduce arbitrage and
improve consistency and accountability. Clear lines of
responsibility will be established.
The FDIC will regulate state banks and
thrifts of all sizes and holding companies of state banks and
thrifts with assets below $50bn.
The Office of the Comptroller of the
Currency will regulate national banks and federal thrifts of
all sizes and the holding companies of national banks and
federal thrifts with assets below $50bn. The Office of Thrift
Supervision is eliminated and there will be no new charters for
The Federal Reserve will
regulate bank and thrift holding companies with assets of over
$50bn, drawing on its capital market experience. As a
consolidated supervisor, the Federal Reserve is intended to see
risks whether they lie in the bank holding company or its
subsidiaries. It will be responsible for finding risk
throughout the system. The vice-chair of the Federal Reserve
will be responsible for supervision and will report
semi-annually to Congress.
Jon Hay +44 207 779 8372 email@example.com