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Project on Government Oversight




Can Regulators Be Trusted to Crack Down on Derivatives Abuses?

April 29, 2010 


Earlier this week, the Chairs of the Senate Agriculture and Banking Committees reached an agreement on a proposal that could bring sweeping changes to the regulation of over-the-counter (OTC) derivatives. The Democratic leadership announced it will incorporate the joint proposal, which was negotiated by Senators Blanche Lincoln (D-AR) and Christopher Dodd (D-CT), into a substitute amendment for the main bill, which is set to be introduced on the Senate floor any second now. (POGO has obtained a copy of the substitute amendment, which can be viewed here; the section on derivatives begins on page 501).

But even before it’s officially introduced, the Lincoln-Dodd bill has already encountered some stiff opposition.

The controversy surrounding derivatives reform

Staff from the Federal Reserve tried unsuccessfully to kill a provision that would require any financial company carrying insured deposits to spin off its derivatives operation (Sen. Judd Gregg (R-NH) said in a floor statement that this provision amounted to a “virulent populist attack on entities simply because they’re large”). Another controversial provision, introduced by Sen. Ben Nelson (D-NE) following intense lobbying by Warren Buffet, would have exempted any existing derivatives contracts from the bill’s new collateral requirements, although The Wall Street Journal reports that Senate Democrats have nixed this idea.

And while there is widespread agreement that OTC derivatives trading should be made more transparent to regulators and the investing public, there has been much debate about the best way to accomplish this. Legislation passed by the House in December would require all standardized OTC derivatives contracts to be submitted to a clearinghouse, which would guarantee payment to both parties of the contract, rather than having the parties trade with each other through a dealer. The clearinghouse would also be able to provide information about the trade to the appropriate regulators. A separate provision would also require that most standardized and cleared swap transactions be executed on an exchange, which is statutorily required to provide even greater price transparency. The Lincoln-Dodd bill introduced this week contains similar requirements for clearing and exchange-trading.

These proposals have led to some contentious debates over the past few months. Gary Gensler, Chair of the Commodity Futures Trading Commission (CFTC), has been a strong supporter of the clearing provisions, and has criticized language that would provide broad clearing exemptions for so-called “end-users”: non-financial sector companies, municipalities, and non-profits that use derivatives as a standard business practice to hedge against risk. Gensler and others have argued that the end-user campaign has actually been orchestrated by the big dealers on Wall Street, who stand to benefit the most from keeping these deals to themselves.

Meanwhile, POGO and others have been critical of a provision that would provide an alternative to exchange-trading on a venue known as a “swap execution facility.” Our concern, which was recently echoed by former CFTC Director of Trading and Markets Michael Greenberger, is that the vague definition of a swap execution facility would allow derivatives traders to get around the price transparency requirements of an exchange. Others have argued that the clearing issue is much more important, or that it’s possible to encourage more trading on exchanges without making it a mandatory requirement.

Passing the baton to the regulators

These issues are likely to be discussed in much greater detail if and when the bill hits the Senate floor. But no matter what Congress ends up passing in the final legislation, one thing is clear: the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) will still have significant leeway to design and implement the rules governing OTC derivatives trading. For instance, it will probably be up to the regulators to determine the margin requirements for OTC derivatives trades, decide which companies qualify as end-users, establish the rules for swap execution facilities, and so on. Which raises the question: can we trust these regulators to establish rules that follow the spirit and letter of Congress’s bill, and will the regulators actually enforce their own rules?

POGO has written extensively about the enforcement problems at the SEC, which will be in charge of regulating securities-based derivatives. This time the focus is on the CFTC, which will be in charge of regulating pretty much everything else.

CFTC’s mixed enforcement record

Congress created the CFTC in 1974 to regulate the futures and option markets. Since that time, the agency has had a decidedly mixed record when it comes to regulation and enforcement.

In 1992, CFTC Chair Wendy Gramm pushed through a rule change that narrowed the definition of futures contracts, effectively excluding Enron’s energy future contracts and interest rate swaps from the agency’s oversight (she later went to serve on Enron’s board).

Mary Schapiro took over as Chair in 1994, observing at the time that “people were banking on the fact that the CFTC would be a sleepy little agency,” and promising to ramp up the regulation of derivatives, among other things. She was credited with revamping the enforcement division, opening more cases, and collecting more penalties than her predecessor did, but she left the agency one year later to become the chief regulator at the private National Association of Securities Dealers (NASD), where she eventually oversaw a controversial merger leading to the creation of the Financial Industry Regulatory Authority (FINRA).

In 1998, CFTC Chair Brooksley Born began sounding the alarm about the systemic risk posed by the OTC derivatives market, and pushed hard for increased regulatory authority, but was rebuffed by officials in the Clinton administration. Two years later, Congress passed the Commodity Futures Modernization Act, which stated that most OTC derivatives transactions would not be regulated as “futures” under the Commodity Exchange Act, and therefore would not be regulated by the CFTC.

And in the past few years, the CFTC’s enforcement stats have been stagnant at best:


Number of...







Enforcement investigations opened







Enforcement cases filed







Cases filed by other criminal and civil law enforcement authorities with cooperative assistance from the CFTC







Of course, these stats are likely to increase in the years to come, as the CFTC receives a budget boost that will enhance its ability to crack down on fraud and abuse in the $450 trillion OTC derivatives market. Nonetheless, the CFTC’s long-standing reputation as a “sleepy little agency” raises concerns about its future enforcement prospects.

A cozy relationship with industry?

As is often the case with government regulators, the CFTC’s effectiveness depends in large part on the quality of the officials who occupy the agency’s top management positions.

The current Chairman, Gary Gensler, has proven to be a strong advocate for increased regulation, and has even been accused of having an overbearing role in the crafting of Congress’s legislation. But Gensler’s current position is surprising, given that he worked for 18 years at Goldman Sachs, one of the five big dealers that stand to lose if OTC derivatives trading is pushed onto clearinghouses and exchanges. Gensler also served in Clinton’s Treasury Department at the time when it dismissed Brooksley Born’s proposal to regulate OTC derivatives.

Gensler’s newfound reformist streak is encouraging. But a quick glance at the employment history of other CFTC Commissioners suggests a strong industry influence among some of the agency’s top officials.

For example, former Commissioner Reuben Jeffrey III also spent 18 years working for Goldman Sachs. And one of the current Commissioners, Jill Sommers, was once the Policy Director and Head of Government Affairs for the International Swaps and Derivatives Association (ISDA), the trade association for OTC derivatives market participants. Prior to that, she worked at the Chicago Mercantile Exchange, where she “had the opportunity to work closely with congressional staff drafting the Commodity Futures Modernization Act,” the bill that exempted OTC derivatives from the CFTC’s regulation.

To be sure, the presence of officials with an industry background shouldn’t necessarily prevent the CFTC from being a tough watchdog. And with Gensler at the helm, we’re hopeful that the agency will be able to create and implement an effective regulatory framework for OTC derivatives trading. But by giving the CFTC and other regulators significant leeway to design and enforce the rules, Congress is leaving open the possibility that the rules could one day be watered down by officials who aren’t so keen on standing up to industry.

Founded in 1981, the Project On Government Oversight (POGO) is a nonpartisan independent watchdog that champions good government reforms. POGO's investigations into corruption, misconduct, and conflicts of interest achieve a more effective, accountable, open, and ethical federal government.

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