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CFTC and SEC Divvy up Derivatives Pie, CME’s Donohue Expresses Concern About Illiquid Derivatives

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Following a brief hiatus, the turf war is back on between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Just how the two regulators will divide up the oversight of the derivatives market is currently being debated across the industry and could have wide ramifications for those involved in the sector.

SEC chairman Mary Schapiro is keen to get more authority over more OTC products including securities related swaps, and has been vigorously lobbying Congress over the last week to that end. “Primary responsibility for securities related OTC derivatives would be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives,” Schapiro said in testimony before the Senate Banking Subcommittee on Securities earlier this week.

She contended that oversight of foreign exchange, interest rate and commodity swaps should be the remit of the CFTC, while the Fed should oversee systemically important banks that are involved in the derivatives business. Schapiro stressed that firms should not be subject to duplicative oversight processes: “OTC derivatives dealers that are banks would be subject to prudential supervision by their federal banking regulator. All other OTC derivatives dealers in securities related OTC derivatives would be subject to supervision and regulation by the SEC.”

This is a rather difficult proposition given the circumstances and it also sustains the current confusing patchwork of regulatory oversight in the country. Turf battles are likely to reoccur in the future as regulators are forced to negotiate which financial institutions fall under their remit. The likely impact on these firms is the imposition of more onerous reporting requirements by regulators seeking to prove their competence. Duplicative reporting processes may also be maintained and this could have a significant impact on their compliance, record keeping and reporting systems.

The plans will also require all standardised OTC products to go through clearing houses in order to reduce counterparty risk in the market. Moreover these products will also be required to be traded by electronic execution methods, whereas more complex OTC derivatives will be subject to new mandatory reporting requirements. This data on complex products would then be stored in a trade repository for regulatory reference purposes.

The plan for clearing OTC derivatives has stirred up some controversy in the market already. For example, this week, Craig Donohue, chief executive of CME Group, indicated that he believes it would be dangerous for all these products to be forced into being cleared electronically. “We have to be careful to manage the risk profile of what we clear and there will be a range of things that we would not be comfortable clearing,” he warned.

Donohue is keen for the market to have some sway in deciding what is centrally cleared, rather than being forced to clear all standardised trades. “We want to be able to make the decision to clear what we feel comfortable with from a risk perspective,” he said.

These concerns are warranted and, given the focus on systemic risk, are likely to be seconded by a number of other participants in the market. However, much like deciding how big each regulator’s share of the derivatives pie will be, it will be up to the powers that be to decide whether these warnings are heeded.

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