The financial reforms being considered by the US Congress
seem fundamentally sound.
First, find out the size, shape and behavior of
over-the-counter transactions by putting as many as possible on
to visible trading venues. Second, establish a reliable system
of collateralization for them, following the adage "In God we
trust, the rest pay cash".
Finally, provide the safety net of a central counterparty
clearing mechanism that can rescue a deal even when the direct
parties and their intermediaries have exhausted their
But the reforms include two features that seem weird. First,
the classification of credit default swaps (CDS) as securities.
And second – despite having had a decade in which to
learn better – Congress expects the Securities and
Exchange Commission and the Commodity Futures Trading
Commission to develop joint regulations (or at least, lookalike
The oddity of treating CDS as securities is that they are
structured quite differently.
It is true that they are options: you pay me a fee and I
will pay you a principal amount if a financial instrument
(quite likely a security) defaults.
But unlike the normal equity options that are regulated by
the SEC, the value of CDS does not rise and fall in tandem with
the price of the underlying security and they convey neither a
right to buy nor a right to sell that security.
In fact, CDS have all the hallmarks of insurance policies,
and are therefore simply event-linked options of the type that
the CFTC normally regulates.
A CDS exists to encourage people to hedge against their
risks – the focus of the CFTC’s activity
– rather than to encourage people to contribute
capital to the economy – the SEC’s
More concerning is the bill’s desire that the
SEC and CFTC coordinate their standards in some areas. Notably,
they would have to cooperate on regulating security-based swaps
(at the SEC) and all other swaps (at the CFTC).
Pious hopes that the two agencies will get along have
informed legislation before. Back in 2000, Congress asked them
to co-regulate futures on single corporate securities and on
small stock indices. They would have no difficulty agreeing on
In fairness, the two regulators did create rules to launch a
basic equity futures trading program on both the futures and
securities exchanges. And, in 2006, they widened it to include
futures on debt securities as well.
But the fact that it took six years to make even that small
leap was unsettling to many observers.
Other joint initiatives planned in 2000 remain today unused
or in hopeless chaos. Here are two examples.
The legislation that set up co-regulation for security
futures said the SEC and CFTC could authorize trading of
options on those futures in late 2003. As of mid-2010, nothing
Nine year stalemate
The same statute recognized a need to address the treatment
of security futures listed on overseas markets. The laws
administered by both agencies were amended to call for the
adoption of joint regulations on this subject.
The CFTC’s legislation took a step toward
addressing this question by declaring that foreign-listed
security futures could be traded by anyone located outside the
US and by any individual or entity that could meet standards
applicable to "eligible contract participants".
That means US individuals whose total assets exceed $10m, or
$5m if they are hedgers. For US entities, the hedging bar is
lower, at $1m.
Alas, no similar change occurred in the SEC’s
statutes. As a result, activity that was explicitly lawful
under the CFTC regime remained silently banned in the SEC
world, awaiting the adoption of joint regulations.
From 2000 until mid-2009, that conundrum remained. Then,
having been ordered by the Congress in 2008 to do something by
the end of June 2009, the SEC acted.
But not without showing its displeasure. First, it waited
until the very last day of June 2009 to comply. Then, it
unilaterally adopted an exemptive order, setting standards
radically different from what the Congress had selected in 2000
for the CFTC’s statute.
In brief, the SEC limited US participation in foreign-listed
security futures to "qualified institutional buyers", a term
that generally requires the possession of $100m of investments
in unaffiliated issuers.
This is 10 times the CFTC threshold even for US speculators
and as much as 100 times the CFTC requirement for hedging
Which raises one last question about the efficacy of joint
rulemaking. The clause added to the statutes of both the SEC
and the CFTC in 2000 required joint rulemaking on
foreign-listed security futures. The act did not give the SEC
authority to act alone by setting its own standards, through an
exemptive order or any other means. Is the SEC’s
Congress would do well in its current financial reform
debate to heed this experience and to allow the SEC and the
CFTC to fashion their own separate programs for the new
authority they will soon be assuming.
Philip McBride Johnson is head of the derivatives
regulatory practice at Skadden, Arps, Slate, Meagher and Flom
in Washington and a past chairman of the CFTC.