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Consumer Financial Protection Agency Act of 2009

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As part of the new Obama financial regulation plan, which includes potentially the registration of hedge fund managers with the SEC, the Whitehouse has sent a draft to congress of the new Consumer Financial Protection Agency Act of 2009 (CFPAA of 2009).  The act would create a new government agency which would have some interaction with both the SEC and the CFTC.  A full version of the draft can be found here: Consumer Financial Protection Agency Act of 2009.  Additionally, you can find President Obama’s statement with regard to this new agency reprinted below.  For more information, please also see Jim Hamilton’s website.

More posts about this new act and what it will mean to hedge funds will be forthcoming.

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THE WHITE HOUSE

Office of the Press Secretary
EMBARGOED UNTIL 6:00 AM ET,

SATURDAY, June 20, 2009

WEEKLY ADDRESS: President Obama Highlights Tough New Consumer Protections

WASHINGTON – In his weekly address, President Barack Obama explained the necessity of his proposed Consumer Financial Protection Agency.  It is clear that one of the major causes of the current economic crisis was a breakdown of oversight leading to widespread abuses in the financial world.  The Consumer Financial Protection Agency will have the sole job of looking out for the financial interests of ordinary Americans by banning unfair practices and enforcing the rules.  This is the type of reform that will attack the causes of the current crisis and prevent further crises from taking place.

The audio and video will be available at 6:00am Saturday, June 20, 2009 at www.whitehouse.gov.

Prepared Remarks of President Barack Obama
Weekly Address
June 20, 2009

As we continue to recover from an historic economic crisis, it is clear to everyone that one of its major causes was a breakdown in oversight that led to widespread abuses in the financial system. An epidemic of irresponsibility took hold from Wall Street to Washington to Main Street.  And the consequences have been disastrous. Millions of Americans have seen their life savings erode; families have been devastated by job losses; businesses large and small have closed their doors.

In response, this week, my administration proposed a set of major reforms to the rules that govern our financial system; to attack the causes of this crisis and to prevent future crises from taking place; to ensure that our markets can work fairly and freely for businesses and consumers alike.

We are going to promote markets that work for those who play by the rules. We’re going to stand up for a system in which fair dealing and honest competition are the only way to win. We’re going to level the playing field for consumers. And we’re going to have the kinds of rules that encourage innovations that make our economy stronger – not those that allow insiders to exploit its weaknesses for their own gain.

And one of the most important proposals is a new oversight agency called the Consumer Financial Protection Agency. It’s charged with just one job: looking out for the interests of ordinary Americans in the financial system. This is essential, for this crisis may have started on Wall Street.  But its impacts have been felt by ordinary Americans who rely on credit cards, home loans, and other financial instruments.

It is true that this crisis was caused in part by Americans who took on too much debt and took out loans they simply could not afford. But there are also millions of Americans who signed contracts they did not always understand offered by lenders who did not always tell the truth. Today, folks signing up for a mortgage, student loan, or credit card face a bewildering array of incomprehensible options. Companies compete not by offering better products, but more complicated ones – with more fine print and hidden terms.  It’s no coincidence that the lack of strong consumer protections led to abuses against consumers; the lack of rules to stop deceptive lending practices led to abuses against borrowers.

This new agency will have the responsibility to change that. It will have the power to set tough new rules so that companies compete by offering innovative products that consumers actually want – and actually understand. Those ridiculous contracts – pages of fine print that no one can figure out – will be a thing of the past. You’ll be able to compare products – with descriptions in plain language – to see what is best for you.  The most unfair practices will be banned. The rules will be enforced.

Some argue that these changes – and the many others we’ve called for – go too far. And I welcome a debate about how we can make sure our regulations work for businesses and consumers. But what I will not accept – what I will vigorously oppose – are those who do not argue in good faith. Those who would defend the status quo at any cost. Those who put their narrow interests ahead of the interests of ordinary Americans. We’ve already begun to see special interests mobilizing against change.

That’s not surprising. That’s Washington.

For these are interests that have benefited from a system which allowed ordinary Americans to be exploited. These interests argue against reform even as millions of people are facing the consequences of this crisis in their own lives. These interests defend business-as-usual even though we know that it was business-as-usual that allowed this crisis to take place.

Well, the American people did not send me to Washington to give in to the special interests; the American people sent me to Washington to stand up for their interests.  And while I’m not spoiling for a fight, I’m ready for one. The most important thing we can do to put this era of irresponsibility in the past is to take responsibility now. That is why my administration will accept no less than real and lasting change to the way business is done – on Wall Street and in Washington. We will do what is necessary to end this crisis – and we will do what it takes to prevent this kind of crisis from ever happening again.

Thank you.

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Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Regulation Principles

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IOSCO Pushes Securities Regulators to Adopt Registration Provisions

Over the past few months we have been highlighting the Congressional attempts to regulate and/or register hedge funds and more recently have discussed the Obama hedge fund registration plan.  However, we have not discussed what is happening internationally.  Like the in the US, other major financial centers around the world have suffered from the economic downturn and have begun looking towards greater regulation of the financial system – this of course means greater regulation of hedge funds and registration for hedge fund managers.

There has been much discussion, both in the US and abroad, about world-wide principles for regulation.  There would be obvious benefits for some sort of international standards for all parts of the financial system, but there would need to be an unprecedented amount of cooperation between the various financial regulatory agencies which seems like an insurmountable task.  However, one group, the International Organization of Securities Commissions’ (IOSCO), is doing its best to act as a sort of communicator of best practices that financial regulatory systems should integrate into new regulations which are expected to be proposed in many jurisdictions.

Below I have published a press release announcing the IOSCO’s report on hedge fund oversight.  The full 26 page report, IOSCO Hedge Fund Regulation Report, tackles some of the high level issues which regulatory bodies should consider when drafting new hedge fund regulations.  It will be interesting to see how this report is received in the different jurisdictions throughout the world.

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IOSCO/MR/12/2009
Madrid, 22 June 2009

IOSCO publishes principles for hedge funds regulation

The International Organization of Securities Commissions’ (IOSCO) Technical Committee has today published Hedge Funds Oversight: Final Report which contains six high level principles that will enable securities regulators to address, in a collective and effective way, the regulatory and systemic risks posed by hedge funds in their own jurisdictions while supporting a globally consistent approach.

The report, which was prepared by the Task Force on Unregulated Entities (Task Force), recommends that all securities regulators apply the principles in their regulatory approaches.

The six high level principles are:

  1. Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration;
  2. Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to:
    1. Organisational and operational standards;
    2. Conflicts of interest and other conduct of business rules;
    3. Disclosure to investors; and
    4. Prudential regulation.
  3. Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds;
  4. Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks);
  5. Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate;
  6. Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

Kathleen Casey, Chairman of the Technical Committee, said:

“Securities regulators recognise that the current crisis in financial markets is not a hedge fund driven event. Hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. Nevertheless the crisis has given regulators the opportunity to consider the systemic role hedge funds may play and the way in which we deal with the regulatory risks they may pose to the oversight of markets and protection of investors.

“The application of these principles, in a collective, cooperative and efficient way, can provide regulators with the tools to obtain sufficient, relevant information in order to address the regulatory and systemic risks posed by hedge funds.”

The Task Force was chaired by the CONSOB of Italy and the Financial Services Authority of the United Kingdom. It was established in November 2008 to support the initiatives undertaken by the G-20 to restore global growth and achieve reforms in the world’s financial systems.

The Task Force will continue to work to support the implementation of these standards by its members and to deal with future regulatory issues that may arise in relation to hedge funds. It will act as the contact point with prudential regulators and banking standards setters, as well as other regulatory bodies such as the Joint Forum and the hedge fund industry in relation to the development and implementation of industry standards of best practice.

NOTES FOR EDITORS

1. Hedge Funds Oversight – Final Report of the Technical Committee of IOSCO is available on IOSCO’s website.

2. Hedge Funds Oversight – Consultation Report of the Technical Committee of IOSCO was published on 30 April 2009.

3. IOSCO is recognized as the leading international policy forum for securities regulators. The organization’s wide membership regulates more than 95% of the world’s securities markets and IOSCO is the international cooperative forum for securities regulatory agencies. IOSCO members regulate more than one hundred jurisdictions and its membership is steadily growing.

4. The Technical Committee, a specialised working group established by IOSCO’s Executive Committee, is made up of eighteen agencies that regulate some of the worlds larger, more developed and internationalized markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms. Kathleen Casey, Commissioner of the United States Securities and Exchange Commission is the Chairman of the Technical Committee. The members of the Technical Committee are the securities regulatory authorities of Australia, Brazil, China, France, Germany, Hong Kong, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, United Kingdom and the United States.

5. IOSCO aims through its permanent structures:

  • to cooperate together to promote high standards of regulation in order to maintain just, efficient and sound markets;
  • to exchange information on their respective experiences in order to promote the development of domestic markets;
  • to unite their efforts to establish standards and an effective surveillance of international securities transactions;
  • to provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses.

MEDIA ENQUIRIES
Greg Tanzer
Direct Line + 34 91 417 5549
Email: [email protected]
Website: www.iosco.org

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CFTC Chairman Speaks to MFA

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Chairman Gary Gensler Discusses Over-the-Counter Derivatives Regulation and Hedge Funds

CFTC Chairman Gary Gensler has been busy lately testifying before Congress and now speaking to the Managed Futures Association.  His remarks to the MFA, which can be found here and which are reprinted in full below, mirror his earlier statements to the Congress regarding the regulation of OTC derivates and hedge fund registration (see Congress and Regulators Discuss OTC Derivatives).  Gensler’s comments are generally seen as reasonable but aggressive and we are seeing an increase in the political power of the CFTC in general and vis-a-vis the SEC (with respect to certain issues at least).  I am very interested in how these issues will play out in the political process over the next few month.

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Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
202.418.5080

Remarks of Chairman Gary Gensler Before the Managed Funds Association, Chicago, Illinois

June 24, 2009

Thank you for that introduction, Richard. I greatly appreciate the invitation to speak to the Managed Funds Association at this critical time in our nation’s economy. The last time the two of us were together with a crowd of this size, I was testifying as an Undersecretary at the Department of the Treasury before your Committee in the U.S. House of Representatives. Once again, we’re together discussing challenges facing our financial system and possible solutions.

As President Obama announced exactly one week ago, we must urgently enact broad regulatory reforms of our financial system. The President’s proposal offers bold reforms seeking to prevent the financial breakdowns that led to our current crisis. It is sweeping in scope, cutting across the financial system to provide greater oversight, transparency and accountability.

Today I would like to focus on two key areas: regulation of over-the-counter derivatives and hedge funds.

Over-the-Counter Derivatives

We must establish a regulatory regime to cover the entire over-the-counter derivatives marketplace.
This will help the American public by: One – lowering systemic risk. Two – providing transparency and efficiency in markets. Three – ensuring market integrity by preventing fraud, manipulation, and other abuses. And four – protecting the retail public.

This new regime should govern 100% of OTC derivatives no matter who is trading them or what type of derivative is traded, standardized or customized. That includes interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps or those which cannot yet be foreseen.

I envision this will require two complementary regimes — one for regulation of the dealers and one for regulation of the market functions. Together, with both of these, we will ensure that the entire derivatives marketplace is subject to comprehensive regulation.

The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system. The costs to the public from the failure of these firms has been staggering, $180 Billion of American taxpayer financial support for AIG alone. The AIG subsidiary that dealt in derivatives – AIG Financial Products –was not subject to any effective federal regulation. Nor were the derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks. As such, all derivatives dealers need to be subject to robust federal regulation.

Regulation of the dealers should set capital standards and margin requirements to lower risk. We also must set business conduct standards. These standards would guard against fraud, manipulation, and other market abuses. Additionally, they would lower risk by setting important back office standards for timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. Lastly, we must also mandate recordkeeping and reporting to promote transparency and to allow the CFTC and SEC to vigorously enforce market integrity.

By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we ensure that all OTC products, both standardized and customized, are subject to robust oversight. Particular care should be given to ensure that no gaps exist between the regulation of standardized and customized products. Customized derivatives, though allowed, would be subject to capital, margin, business conduct and reporting standards. Customized derivatives, however, are by their nature less standard, less liquid and less transparent. Therefore, I believe that higher capital and margin requirements for customized products are justified.

Beyond regulating the dealers, I believe that we must mandate the use of central clearing and exchange venues for all standardized derivatives. Derivatives that can be moved into central clearing should be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.

Requiring clearing will promote market integrity and lower risks. Individual firms will become less interconnected as OTC transactions are netted out through centralized clearing. Furthermore, mandated clearing will bring the discipline of daily valuation of transactions and the posting of collateral.

I also would like to highlight three essential features for OTC central clearinghouses:

  • Governance arrangements should be transparent and incorporate a broad range of viewpoints from members and other market participants,
  • Central counterparties should be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm, and
  • Finally, in order to promote clearing and achieve market efficiency through competition, OTC derivatives should be fungible and able to be transferred between one exchange or electronic trading system to another.

Market transparency and efficiency would be further improved by requiring the standardized part of the OTC markets onto fully regulated exchanges and fully regulated transparent electronic trading systems. Experience has shown that President Franklin Roosevelt’s approach is correct. To function well, markets must be properly-regulated and transparent. They simply cannot police themselves nor remain in the dark.

Regulated exchanges and regulated transparent trading systems will bring much needed transparency to OTC markets. Market participants should be able to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions.

Market regulators should have authority to impose recordkeeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses.

The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.

To fully achieve these objectives, we must enact both of these complementary regimes. Regulating both the traders and the markets will ensure that we cover both the actors and the stages that may create significant risks.

Hedge Funds

The second topic that I would like to discuss is regulation of hedge funds. President Obama has called for advisers to hedge funds and other investment funds to register with the SEC under the Investment Advisers Act. Advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

The Commodity Exchange Act (CEA) currently provides that funds trading in the futures markets register as Commodity Pool Operators (CPO) and file annual financials with the CFTC. Over 1300 CPOs, including many of the largest hedge funds, are currently registered with and make annual filings to the CFTC. It will be important that the CFTC be able to maintain its enforcement authority over these entities as the SEC takes on important new responsibilities in this area.

This financial crisis also gave new meaning to the term “run on the bank”. Upon hearing those words, most of us would conjure up the image of the citizens of Bedford Falls standing outside George Bailey’s Savings and Loan in the movie It’s a Wonderful Life. Last year, we witnessed the modern version of this in a number of ways. A harsh lesson of the crisis occurred when a significant number of hedge funds sought to pull securities and funds from their prime brokers, contributing to uncertainty and the destabilization of the financial system.

You may be aware of proposals being discussed by the International Organization of Securities Commissions (IOSCO) regarding the relationship between hedge funds and their prime brokerages and banks, which will require new oversight and rules of the road. Here at home, we should seriously consider similar principles to best guard against runs on liquidity by hedge funds.

In an effort to harmonize financial market oversight, the President requested the CFTC and SEC to provide a report to Congress by September 30, 2009. We will identify existing differences in statutes and regulations with respect to similar types of financial instruments, explain if differences are still appropriate, and make recommendations for changes. In developing recommendations for harmonization we will seek broad input from the public, other regulators, and market users.

Before closing, I would like to mention Chairman Levin’s report on wheat convergence released today by the Senate Permanent Subcommittee on Investigations. Chairman Levin’s report is a significant contribution to discussions regarding the potential effects of index trading in the wheat market and other commodity futures markets. As the Commission continues our own analysis and appropriate regulatory responses, Chairman Levin’s recommendations will be carefully considered.
I would like to thank you again for having me here today, and I am happy to take questions.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Congress and Regulators Discuss OTC Derivatives Regulation

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Increased regulation looming as SEC and CFTC jockey for position

The  severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation, as well as the pressing need for a comprehensive regulatory framework.  Part of President Obama’s new financial regulation plan is to regulate the over the counter (OTC) derivatives markets.  On June 22nd, 2009, both the SEC and CFTC testified to congress regarding the regulation of these markets.

Chairman Mary Shapiro (SEC) and Chairman Gary Gensler (CTFC) each testified before Congress to address the existing gaps in regulatory oversight of these securities-related OTC derivatives, and propose a new framework that would provide expand regulatory authority of the CTFC and SEC to oversee the OTC markets. The primary goal of the proposed regulatory reform measures is to achieve the following four primary objectives:

  1. preventing activities in the OTC derivatives markets from posing risk to the financial system;
  2. promoting efficiency and transparency of those markets;
  3. preventing market manipulation, fraud, and other market abuses; and
  4. ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

I have reprinted the entire SEC testimony and CFTC testimony below.

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Testimony Concerning Regulation of Over-The-Counter Derivatives
by Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission
Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing and Urban Affairs
United States Senate
June 22, 2009

I. Introduction

Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee:

I am pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission concerning the regulation of over-the-counter (“OTC”) derivatives. The severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation. One of these is the gap in regulation of OTC derivatives, which under current law are largely excluded or exempted from regulation. The SEC is committed to working closely with this Committee, the Congress, the Administration, and fellow regulatory agencies to close this gap and restore a sound structure for U.S. financial regulation.

My testimony today on the regulation of OTC derivatives will reflect the SEC’s perspective as the country’s capital markets regulator. First, I will give an overview of the OTC derivatives markets, with particular focus on those derivatives products that are directly related to or based on securities or issuers of securities and therefore directly connected with the SEC’s statutory mandate. Second, I will outline an approach that would address the existing gaps in regulatory oversight of these securities-related OTC derivatives.

I must tell you right at the start that, given the current limited regulation of OTC derivatives, no regulatory authority can give you a complete picture of OTC derivatives and how they have affected the regulated securities markets. One reason that we need legislation is that our sources of information about securities-related OTC derivatives products, participants, and trading are limited, particularly when contrasted with the tools we have to monitor the markets for other securities products subject to the federal securities laws.

The good news, however, is that the U.S. regulatory authorities have reached a broad consensus on the pressing need for a comprehensive regulatory framework for OTC derivatives. As reflected in Treasury Secretary Geithner’s letter to the Congressional leadership on May 13, 2009, this consensus covers all of the basics of sound financial regulation in the 21st century, including recordkeeping and reporting requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing.

One important aspect of a new regulatory framework will be well-regulated central counterparties (“CCPs”). CCPs address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. For this reason, CCPs contribute generally to the goal of market stability. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, CCPs help protect the broader financial system. It is important to note that achieving standardization, a prerequisite for centralized clearing, may present significant challenges.

U.S. regulators agree on the objectives of a new regulatory framework for OTC derivatives that will protect the public interest, manage systemic risk, and promote capital formation and general economic welfare. Any new regulatory framework, however, should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk. My goal today is to assist the Congress as best I can in its efforts to craft legislation that empowers the respective regulatory authorities to do their jobs effectively in any new framework. I am confident that, working together, we will meet the challenge that is so important to the financial well-being of individual Americans.

II. Overview of Securities-Related OTC Derivatives

A derivative is a financial instrument whose value is based on the value of an underlying “reference” (e.g., an asset such as a commodity, bond, equity, or currency, or an index of such assets, or an event). For example, in exchange for $100 today, financial institution “A” will pay counterparty “B” $150 if “something” happens (something can be almost anything: Z company defaults on its debt payments; the S&P 500 falls 10%; the Dow rises 5%). A derivative is “OTC” when it is not traded on a regulated exchange. An OTC derivative is “securities-related” when the reference is to an entity that is an issuer of securities (such as a public company), to a security itself (or a related event such as a dividend payment), to a group or index of securities or issuers, or based on related aspects of a security or group or index of securities or issuers, such as price, yield, volatility, dividend payments, or value.

An OTC derivative is an incredibly flexible product that can, essentially, be engineered to achieve almost any financial purpose between two parties. Indeed, as I will discuss later, an OTC derivative can enable market participants to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves. Transactions occurring in the OTC derivatives markets can serve important economic purposes such as allowing market participants to hedge exposure and manage risk. When market participants engage in these types of transactions in the OTC derivatives markets, the transactions, which are substantially similar to traditional securities transactions, and the parties engaged in them, would fall outside the current reach of key provisions of the federal securities laws.

OTC derivatives are largely excluded from the securities regulatory framework by the Commodity Futures Modernization Act of 2000.1 In a recent study on a type of securities-related OTC derivative known as a credit default swap, or CDS, the Government Accountability Office found that “comprehensive and consistent data on the overall market have not been readily available,” that “authoritative information about the actual size of the CDS market is generally not available,” and that regulators currently are unable “to monitor activities across the market.”

One source of information on OTC derivatives volume is the data collected by the Bank for International Settlements (“BIS”). BIS data cover the OTC derivatives exposure of major banks and dealers in the G10 countries. For all OTC derivatives in December 2008, BIS reported a notional amount outstanding of $592 trillion and a gross market value outstanding of $34 trillion. Interest rate contracts and foreign exchange contracts are the two largest sources of OTC derivatives volume. For those types of products that appear to be securities-related credit derivatives and equity derivatives in December 2008, BIS reported a notional amount outstanding of $48.4 trillion and a gross market value outstanding of $6.8 trillion. A notional amount of $70 trillion and a gross market value of $5 trillion are “unallocated” for December 2008. Clearly, this volume of largely unregulated financial activity is enormous, even when just considering the relatively small volume component that is securities-related.

Who are the major participants in the securities-related OTC derivatives markets? First, the markets are concentrated and appear to be almost exclusively “dealer-intermediated” — that is, one of a small number of major dealers is a party to almost all transactions, whether as a buyer or a seller. The customers of the dealers appear to be almost exclusively institutions. Many of these may be highly sophisticated, such as large hedge funds and other pooled short-term trading vehicles. As you know, many hedge funds have not been subject to direct regulation by the SEC and, accordingly, we have very little ability to obtain information concerning their trading activity at this point.

Other customers in the securities-related OTC derivatives markets have been institutions for which derivatives products may not be a suitable investment. In this regard, there is consensus among U.S. regulators reflected in Secretary Geithner’s letter is to ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties. The SEC and CFTC staff, together with other financial regulators, currently are considering a tiered approach to regulation, with scaling that could be based in the first instance on indicia of sophistication and financial thresholds, with requirements for additional disclosure and standards of care with respect to the marketing of derivatives to less sophisticated counterparties. Implementation of such a regulatory approach would depend on a Congressional grant of authority in this area.

Finally, what are the purposes for which securities-related OTC derivatives may be used? One example of a useful purpose for securities-related OTC derivatives is to manage the risk associated with a particular securities position. An investor with a large position in the debt of a company may seek to reduce or hedge some of the risk associated with that investment by purchasing credit protection in the CDS market. In addition, market participants also may use a securities-related OTC derivative to establish a short position with respect to the debt of a specific company. In particular, a market participant that does not own a bond or other debt instrument of a company may purchase a CDS as a way to short that company’s debt.

Market participants take positions in a wide range of exchange-traded and OTC instruments. It is a market participant’s overall (or net) economic exposure that plays a role in determining the risks to which it is exposed. Because OTC derivatives can be customized, a market participant could take a long position in an index — such as the S&P 100 index — through a securities-related OTC derivative and a short position through another OTC derivative on a subset of the securities in the S&P 100 index. The flexibility to tailor OTC derivative contracts allows a participant to create an economic exposure to as large or small a portion of the market it chooses through one or a combination of contracts. This flexibility allowed by OTC derivatives is one of these contracts’ strengths. Because of the link to regulated securities market, however, it is important that the SEC have the tools to see all related activity so that it is in the best position possible to detect and deter market abuses that can disrupt the integrity of the market.

III. Filling Regulatory Gaps in Oversight of Securities-Related OTC Derivatives

Secretary Geithner’s May 13 letter to the Congressional leadership outlined the Administration’s plan for establishing a comprehensive framework for regulating OTC derivatives. The framework is designed to achieve four broad objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

Secretary Geithner recognized that multiple federal regulatory agencies would play critical roles in implementing the proposed framework, including the SEC and the CFTC. He emphasized that the securities and commodities laws should be amended to ensure that the SEC and CFTC, consistent with their respective missions, have the necessary authority to achieve — together with the efforts of other regulators — the four policy objectives for OTC derivatives regulation.

The final part of my testimony today is intended to follow up on Secretary Geithner’s letter by recommending a straightforward and principled approach for achieving these policy objectives. Stated briefly, 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. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, , would rest with the CFTC.

Under this functional and sensible approach to regulation, OTC derivatives markets that are interconnected with the regulated securities markets would be incorporated within a unified securities regulatory regime. The direct link between securities-related OTC derivatives and securities is such that SEC regulation of the former is essential to the effectiveness of the SEC’s statutory mission with respect to the securities markets. The securities regulatory regime is specifically designed to promote the Congressional objectives for capital markets, which include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. It is important that securities-related OTC derivatives be subject to the federal securities laws so that the risk of arbitrage and manipulation of interconnected markets is minimized.

Over the years, Congress has fashioned a broad and flexible regulatory regime for securities that long has accommodated a wide range of products and trading venues. The products include equities, debt, other fixed income securities, options on securities, exchange-traded funds and other investment companies, and many other types of derivative contracts on securities. Some of these securities products are among the most actively traded financial products in the world, with exchange-listed US equities currently trading approximately 11 billion shares per day. Many other securities products trade rarely, if at all. In addition, securities products trade in many different ways in a wide variety of venues, depending on the particular features of the product. These venues include 11 national securities exchanges with self-regulatory responsibilities, more than 70 alternative trading systems that execute OTC transactions, and hundreds of broker-dealers that execute OTC transactions. Finally, securities products are cleared and settled in a variety of ways depending on the particular characteristics of the product.

The current securities laws are broad and flexible enough to regulate appropriately all of these varied securities products and trading venues. The regulatory requirements are specifically tailored to reflect the particular nature of products and venues and to promote the Congressional objectives for capital markets. Accordingly, securities-related OTC derivatives could be brought under the same umbrella of oversight as the related, underlying securities markets in a relatively straightforward manner with little need to “reinvent the wheel.” Specifically, Congress could make a limited number of discrete amendments to the statutory definition of a security to cover securities-related OTC derivatives. With these definitional changes, securities-related OTC derivatives could be incorporated within an existing regulatory framework that is appropriate for these products.

The rest of my testimony will elaborate on this basic approach. I first will discuss the close relationship between the regulated securities markets and the markets for securities-related OTC derivatives and then sketch an overview of how oversight of such instruments could be integrated with the SEC’s existing oversight of the securities markets.

A. Relationship between the Securities Markets and Securities-Related OTC Derivatives

In fashioning a regulatory framework for OTC derivatives, it is crucial to recognize the close relationship between the regulated securities markets and the now mostly unregulated markets for securities-related OTC derivatives. Securities-related OTC derivatives can be used to establish either a synthetic “long” exposure to an underlying security or group of securities, or a synthetic “short” exposure to an underlying security or group of securities. In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves.

For example, an equity swap on a single equity security or on an index, such as one of the Dow stocks or the Dow itself, would give the holder of the “long” position all of the economic exposure of owning the stock or index, without actual ownership of the stock or index. This would include exposure to price movements of the stock or index, as well as any dividends or other distributions. Similarly, credit default swaps (“CDS”) can be used as synthetic substitutes for the debt securities of one or more companies. Indeed, any exchange of cash for a security can be structured as an OTC derivatives contract.

Because market participants can readily use securities-related OTC derivatives to serve as synthetic substitutes for securities, the markets for these OTC derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the federal securities laws. These objectives include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

1. Investor Protection

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and recordkeeping and reporting (including those that serve as prophylactic measures against fraud, manipulation, or insider trading) that helps to promote enforcement of the securities laws.

The exclusion of certain securities-related OTC derivatives from most of the securities regulatory regime has detracted from the SEC’s ability to uphold its investor protection mandate. For example, in investigating possible market manipulation during the financial crisis, the SEC has used its anti-fraud authority over security-based swaps to gather information about transactions in OTC derivatives as well as in the underlying securities. Yet investigations of these OTC derivative transactions have been far more difficult and time-consuming than those involving cash equities and options. Audit trail data on OTC derivative transactions is not readily available and must be reconstructed manually, in contrast to the data available in the equity markets. The SEC’s enforcement efforts have been seriously complicated by the lack of a mechanism for promptly obtaining critical information — who traded, how much, and when — that is complete and accurate.

In addition, the SEC believes that it is important in the OTC derivatives market, as in the market for securities generally, that parties to transactions have access to financial information and other disclosures so they can evaluate the risks relating to a particular investment to make more informed investment decisions and can value and evaluate their OTC derivatives and their counterparty exposures. For example, this information assists market participants in performing adequate due diligence on their investments and in valuing their OTC derivatives and their other risks.

A basic tenet of functional regulation of securities markets is to have a regulatory regime under which similar products and activities should be subject to similar regulations and oversight. Currently, securities are subject to transparency, active enforcement, and appropriate regulation of business conduct. Whereas securities-related OTC derivatives, which are interconnected with the securities markets (and in some cases are economic substitutes for securities) are not subject to most of these investor protection requirements. The securities laws are uniquely designed to address these issues and should be extended to OTC derivatives.

2. Fair and Orderly Markets

Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities.

For example, credit default swap, or CDS trading is closely related to trading in the underlying securities that compose the capital structure of the companies on which protection is written. Trading practices in the CDS market, whether legitimate or abusive, can affect the securities markets. The CDS market, however, lacks the level of transparency and other protections that characterize the regulated securities markets. As a result, the SEC has been unable to monitor effectively for trading abuses and whether purchasers of CDS protection on an issuer’s debt have sold short the equity securities of that company as a trading strategy, effectively linking activities and changes in the CDS market with those in the cash equity market. These activities in the CDS market could adversely impact the regulated securities markets. Any regulatory reform that maintained distinct regulatory regimes for securities markets and markets for securities-related OTC derivatives would suffer from this same limitation.

The SEC is considering whether reporting under the Exchange Act should apply to security-based OTC derivatives so that the ownership of and transactions in security-based derivatives would be considered ownership of and transactions in the underlying equity security. We are further evaluating whether persons using equity derivatives, such as an equity swap, should be subject to the beneficial ownership reporting provisions of the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

3. Capital Formation

Facilitating capital formation depends on the existence of fair and efficient secondary markets for investors. Purchasers in the primary offering of a company are attracted by secondary markets that enable them to liquidate their positions readily. Less efficient markets can cause potential investors in companies either to find other uses for their funds or to demand a higher rate of return to compensate them for a less efficient secondary market. If a disparity in the regulatory requirements for securities and securities-related OTC derivatives cause securities markets to operate less efficiently, it will harm those companies that depend on the U.S. securities markets to access the capital that is essential for innovation and growth, as well as harming investors and the capital markets as a whole.

Because many securities-related OTC derivatives are allowed to trade outside of the securities regulatory regime, the SEC generally is unable to promote transparency in the trading of these products and efficiency in pricing. As noted above, companies whose securities are affected by the excluded products could suffer from the absence of transparency and efficiency. Moreover, manipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation. Nevertheless, it is important to remember that derivatives transactions, including OTC derivatives transactions, allow parties to hedge and manage risk, which itself can promote capital formation. To the extent the ability to manage risk is inappropriately limited, it can discourage market participation, including by investors.

B. Regulatory Oversight of Securities-Related OTC Derivatives

To provide a unified, consistent framework for securities regulation, Congress should subject securities-related OTC derivatives to the federal securities laws. This result can be achieved simply by clarifying the definition of “security” to expressly include securities-related OTC derivatives, and removing the current express exclusion of swaps from that definition. The SEC then would have authority to regulate securities-related OTC derivatives regardless of how the products are traded, whether on an exchange or OTC, and regardless of how the products are cleared.

1. Definition of Securities-Related OTC Derivatives

OTC derivatives can be categorized generally as securities-related or non-securities-related, based on the different types of underlying assets, events, or interests to which they are related. Securities-related OTC derivatives would include equity derivatives and credit and other fixed income derivatives. Non-securities-related derivatives would include interest rate derivatives, foreign currency derivatives, and all non-financial derivatives. By including securities-related OTC derivatives under the umbrella of the federal securities laws, the SEC would have responsibility over the portion of the OTC derivatives market that is vital to promote its mission of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

In addition, the SEC would continue to regulate those types of OTC derivatives that always have been considered securities, such as OTC security options, certain OTC notes (including equity-linked notes), and forward contracts on securities. These particular types of OTC derivatives always have been included in the definition of security and current law recognizes this fact by excluding these derivatives from the definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act.

2.Regulation of OTC Derivatives Dealers and Major OTC Participants

Under our recommended approach, major participants in the OTC derivatives markets would be subject to oversight and supervision to ensure there are no gaps. To reduce duplication, 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. The SEC would have authority to set appropriate capital requirements for these OTC derivatives dealers. This approach would permit existing OTC derivatives dealers that are banks to continue to engage in OTC derivatives activities without being subject to the full panoply of broker-dealer regulation, while ensuring that all currently unregulated OTC derivatives dealers in securities-related OTC derivatives are subject to appropriate supervision and regulation. Should Congress establish a new systemic risk regulator or systemic risk council, that entity also could help monitor institutions that might present systemic risk.

In addition, the SEC would have authority to establish business conduct standards and recordkeeping and reporting requirements (including an audit trail) for all securities-related OTC derivatives dealers and other firms with large counterparty exposures in securities-related OTC derivatives (“Major OTC Participants”). This “umbrella” authority would help ensure that the SEC has the tools it needs to oversee the entire market for securities-related OTC derivatives. Major OTC Participants also would be required to meet appropriate standards for the segregation of customer funds and securities.

3. Trading Markets and Clearing Agencies

Trading markets and clearing organizations for securities-related OTC derivatives would be subject to registration requirements as exchanges and clearing agencies. Importantly, however, the conditional exemption from exchange registration the SEC provided under Regulation ATS would be available to trading systems for securities-related OTC derivatives. Among other things, Regulation ATS lowers barriers to entry for trading systems in securities because the systems need not assume the full self-regulatory responsibilities associated with being a national securities exchange. Both registered exchanges and ATSs are subject to important transparency requirements. Consequently, expanding the SEC’s authority over securities-related OTC derivatives would promote improved efficiency and transparency in the markets for securities-related OTC derivatives.

Similarly, the regulatory regime for securities clearing agencies would ensure that CCPs for securities-related OTC derivatives impose appropriate margin requirements and other necessary risk controls. The SEC’s historic regulation of clearing agencies under Section 17A of the Exchange Act has resulted in the most efficient, lowest cost clearing in the world. Indeed, the solid performance of securities clearing systems during the financial crisis bears out that they have the resilience to withstand difficult economic conditions. In addition, the regulation of securities clearance and settlement would directly affect market structure and competition in the trading markets for securities-related OTC derivatives. For example, the SEC’s statutory mandate governing clearing agencies prohibits clearing agencies from engaging in anti-competitive practices, such as imposing unreasonable limitations on access to services. Clearing agencies cannot exclude participants merely for executing their trades in a cleared product in a particular venue. This fair access requirement allows for multiple, competing markets, including OTC trading systems and OTC dealers, to trade the same securities and clear through a single clearing organization. The securities clearing system would support both the goal of having the greatest number of OTC derivatives centrally cleared, while retaining flexibility to allow variation in trading venues to meet the trading needs of different instruments and participants.

The SEC already has taken a number of actions to help further the centralized clearing for OTC derivatives, including exempting three CCPs from the requirement to register as securities clearing agencies. These exemptions were issued to speed the operation of central clearing for CDS. They are temporary and subject to conditions designed to ensure that important elements of Commission oversight apply, such as recordkeeping and Commission staff access to examine clearing facilities. In addition, to further the goal of transparency, each clearing agency is required to make publicly available on fair, reasonable, and not unreasonably discriminatory terms end-of-day settlement prices and any other pricing or valuation information that it publishes or distributes.

One important issue is how to deal with those OTC derivative contracts that may be ineligible for central clearing. OTC derivatives may be ineligible for clearing for a variety of reasons, including customized terms and an inability of CCPs to effectively manage the risks. In many cases, there are legitimate economic reasons to engage in customized transactions. Participants in individual transactions, however, should not be permitted to externalize the costs of their decisions, such as by creating additional systemic risk. Regulatory requirements often have costs, but they are costs incurred to protect the public interest and the general economic welfare. One way for regulators to help ensure market participants incorporate all the risks in the terms of a transaction would be to impose appropriate margin and capital requirements on the participants in customized transactions to reflect the risks they pose to market systems generally. This is an area in which the various functional regulators for particular entities could consult closely with any systemic risk agency that Congress might establish.

In addressing all of these issues with respect to OTC derivatives, moreover, the U.S. must coordinate its efforts with those of regulatory authorities abroad as they seek to address similar issues. The global financial crisis is a potent reminder of the extent to which economies around the world are linked by financial practices and market participants. A sound regulatory approach for managing the systemic risk of such practices and participants benefits from the implementation of complementary measures on an international basis.

V. Conclusion

Bringing securities-related OTC derivatives under the umbrella of the federal securities laws would be based on sound principles of functional regulation, would be relatively straightforward to implement, and would promote Congressional policy objectives for the capital markets. A clear delineation of primary regulatory responsibility for OTC derivatives also would help avoid regulatory gaps from arising in the future. Finally, integrating oversight of securities-related OTC derivatives with oversight of the related, underlying securities markets would minimize the extent of dislocation with respect to existing participants and current practices in the OTC derivatives markets, while still achieving the objectives for OTC derivatives regulation set forth in Secretary Geithner’s letter to the Congressional leadership.

Thank you for the opportunity to address issues of such importance for the strength and stability of the U.S. financial system, and the integrity of the U.S. capital markets. I would be pleased to answer your questions.

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Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
202.418.5080

Testimony of Chairman Gary Gensler, Commodity Futures Trading Commission Before the Senate Banking Subcommittee on Securities, Insurance, and Investment
June 22, 2009

Good morning Chairman Reed, Ranking Member Bunning, and Members of the Committee. I am here today testifying on behalf of the Commission.

The topic of today’s hearing, how to best modernize oversight of the over-the-counter derivatives markets, is of utmost importance during this crucial time for our economy. As President Obama laid out last week, we must urgently enact broad reforms in our financial regulatory structure in order to rebuild and restore confidence in our overall financial system.

Such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade. I look forward to working with the Congress to ensure that the OTC derivatives markets are transparent and free from fraud, manipulation and other abuses.

This effort will require close coordination between the SEC and the CFTC to ensure the most appropriate regulation. I’m fortunate to have as a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable expertise in both the security and commodity futures area, which gives me great confidence that we will be able to provide the Congress with a sound recommendation for comprehensive oversight of the OTC derivatives market. We also will work collaboratively on recommendations on how to best harmonize regulatory efforts between agencies as requested by President Obama. Comprehensive Regulatory Framework A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

  • Lower systemic risks;
  • Promote the transparency and efficiency of markets;
  • Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and
  • Protect the public from improper marketing practices.

To best achieve these objectives, two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses. Only with these two complementary regimes will we ensure that federal regulators have full authority to bring transparency to the OTC derivatives world and to prevent fraud, manipulation, and other types of market abuses. These two regimes should apply no matter which type of firm, method of trading or type of derivative or swap is involved.

Regulating Derivatives Dealers:

I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms whose activities in these markets can create large exposures to counterparties. The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. The AIG subsidiary that dealt in derivatives – AIG Financial Products – for example, was not subject to any effective regulation. The derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks were not subject to mandatory regulation either. By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we can oversee and regulate the entire derivatives market. I believe that our laws should be amended to provide for the registration and regulation of all derivative dealers.

The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules, and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

Capital and Margin Requirements:

The Congress should explicitly require regulators to promulgate capital requirements for all derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin requirements, on all transactions by these dealers will help prevent the types of systemic risks that AIG created. No longer would derivatives dealers or counterparties be able to amass large or highly leveraged risks outside the oversight and prudential safeguards of regulators.

Business Conduct and Transparency Requirements:

Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions. To promote market integrity, the business conduct standards should include prohibitions on fraud, manipulation and other abusive practices. For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets.

Business conduct standards should ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. These standards for “back office” functions will help reduce risks by ensuring derivative dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks.

Derivatives dealers also should be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions. These requirements should include retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository. Trade repositories complement central clearing by providing a location where trades that are not centrally cleared can be recorded in a manner that allows the positions, transactions, and risks associated with those trades to be reported to regulators. To provide transparency of the entire OTC derivatives market, this information should be available to all relevant federal financial regulators. Additionally, there should be clear authority for regulating and setting standards for trade repositories and clearinghouses to ensure that the information recorded meets regulatory needs and that the repositories have strong business conduct practices.

The application of these business conduct standards and the transparency requirements will enable regulators to have timely and accurate knowledge of the risks and positions created by the dealers. It will provide authorities with the information and evidentiary record needed to take any appropriate action to address such risks and to protect and police market integrity. In this regard, the CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses.

Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public. No longer should the public be in the dark about the extensive positions and trading in these markets. This public information will improve the price discovery process and market efficiency.

Regulating Derivatives Markets:

In addition to the significant benefits to be gained from broad regulation of derivatives dealers, I believe that additional safety and transparency must be afforded by regulating the derivative market functions as well. All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.  Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted.

Regulating both the traders and the trades will ensure that both the actors and the actions that may create significant risks are covered. Exchange-trading and central clearing are the two key and related components of well functioning markets. Ever since President Roosevelt called for the regulation of the commodities and securities markets in the early 1930s, the CFTC (and its predecessor) and the SEC have each regulated the clearing functions for the exchanges under their respective jurisdiction. The practice of having the agency which regulates an exchange or trade execution facility also regulate the clearing houses for that market has worked well and should continue as we extend regulations to cover the OTC derivatives market.

Central Clearing:

Central clearing should help reduce systemic risks in addition to the benefits derived from comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in the OTC derivatives market are not cleared, and remain as bilateral contracts between individual buyers and sellers.

In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction. They also require the daily posting of margin to cover the daily changes in the value of positions and collect initial margin as extra protection against potential market changes that are not covered by the daily mark-to-market.

The regulations applicable to clearing should require that clearinghouses establish and maintain robust margin standards and other necessary risk controls and measures. It is important that we incorporate the lessons from the current crisis as well as the best practices reflected in international standards. Working with Congress, we should consider possible amendments to the CEA to expand and deepen the core principles that registered derivatives clearing organizations must meet to achieve these goals to both strengthen these systems and to reduce the possibility of regulatory arbitrage. Clearinghouses should have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants.

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing. By novating contracts to a central clearinghouse coupled with effective risk management practices, the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

One of the lessons that emerged from this recent crisis was that institutions were not just “too big to fail,” but rather too interconnected as well. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

In implementing these responsibilities, it will be appropriate to consider possible additional oversight requirements that may be imposed by any systemic risk regulator that Congress may establish.  Under the Administration’s approach, the systemic regulator, would be charged with ensuring consistent and robust standards for all systemically important clearing, settlement and payment systems. For clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC or SEC would remain the primary regulatory, but the systemic regulator would be able to request information from the primary regulator, participate in examinations led by the primary regulator, make recommendations on strengthening standards to the primary regulator and ultimately, after consulting with the primary regulator and the new Financial Services Oversight Council, use emergency authority to compel a clearinghouse to take actions to address financial risks. Exchange-trading. Beyond the significant transparency afforded the regulators and the public through the record keeping and reporting requirements of derivatives dealers, market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. I believe that this should be required of all standardized contracts.

Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions. The Trade Reporting and Compliance Engine (TRACE) system currently required for timely reporting in the OTC corporate bond market may provide a model.

The CFTC and SEC also should have authority to impose recordkeeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses.

In contrast to long established on-exchange futures and securities markets, there is a need to encourage the further development of exchanges and electronic trading systems for OTC derivatives. In order to promote this goal and achieve market efficiency through competition, there should be sufficient product standardization so OTC derivative trades and open positions are fungible and can be transferred between one exchange or electronic trading system to another.

Position Limits:

Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.

Standardized and Customized Derivatives:

It is important that tailored or customized swaps that are not able to be cleared or traded on an exchange be sufficiently regulated. Regulations should also ensure that customized derivatives are not used solely as a means to avoid the clearing and exchange requirements. This could be accomplished in two ways. First, regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps. Second, we must ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems.

One way to ensure this would be to establish objective criteria for regulators to determine whether, in fact, a swap is standardized. For example, there should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared. Additional potential criteria for consideration in determining whether a contract should be considered to be a standardized swap contract could include:

  • The volume of transactions in the contract;
  • The similarity of the terms in the contract to terms in standardized contracts;
  • Whether any differences in terms from a standardized contract are of economic significance; and
  • The extent to which any of the terms in the contract, including price, are disseminated to third parties.

Criteria such as these could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them “customized.  Regardless of whether an instrument is standardized or customized, or traded on an exchange or on a transparent electronic trade execution system, regulators should have clear, unimpeded authority to impose recordkeeping and reporting requirements, impose margin requirements, and prevent and punish fraud, manipulation and other market abuses. No matter how the instrument is traded, the CFTC and SEC as appropriate also should have clear, unimpeded authority to impose position limits, including aggregate limits, to prevent excessive speculation. A full audit trail should be available to the CFTC, SEC and other Federal regulators.

Authority:

To achieve these goals, the Commodity Exchange Act and security laws should be amended to provide the CFTC and SEC with clear authority to regulate OTC derivatives. The term “OTC derivative” should be defined, and clear authority should be given over all such instruments regardless of the regulatory agency. To the extent that specific types of OTC derivatives might overlap agencies’ existing jurisdiction, care must be taken to avoid unnecessary duplication.

As we enact new laws and regulations, we should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under pre-existing, valid agreements or to nullify pre-existing contractual obligations.

Achieving the Four Key Objectives:

Overall, I believe the complimentary regimes of dealer and market regulation would best achieve the four objectives outlined earlier. As a summary, let me review how this would accomplish the measures applied to both the derivative dealers and the derivative markets.

Lower Systemic Risk:

This dual regime would lower systemic risk through the following four measures:

  • Setting capital requirements for derivative dealers;
  • Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
  • Requiring centralized clearing of standardized swaps; and
  • Requiring business conduct standards for dealers.

Promote Market Transparency and Efficiency:

This complementary regime would promote market transparency and efficiency by:

  • Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;
  • Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;
  • Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to regulators;
  • Requiring centralized clearing of standardized swaps;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
  • Requiring the timely reporting of trades and prompt dissemination of prices and other trade information;

Promote Market Integrity:

It would promote market integrity by:

  • Providing regulators with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;
  • Providing regulators with authority to set position limits, including aggregate position limits;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
  • Requiring business conduct standards for dealers.

Protect Against Improper Marketing Practices:

It would ensure protection of the public from improper marketing practices by:

  • Business conduct standards applied to derivatives dealers regardless of the type of instrument involved; and
  • Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities.

Conclusion:

The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress swiftly responded to the clear need for reform by enacting the Securities Exchange Act of 1934. Two years later it passed the Commodity Exchange Act of 1936.

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide regulators with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Today’s complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage.

These policies are consistent with what I laid out to this committee in February and the Administration’s objectives. I look forward to working with this Committee, and others in Congress, to accomplish these goals.

Mr. Chairman, thank you for the opportunity to appear before the Committee today. I look forward to answering any questions.

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1 Reply

With all of the talk lately of new hedge fund regulations proposed by Obama and the likelihood of investment adviser registration for hedge fund managers, the focus has remained squarely on how to avoid hedge fund fraud situations and another Madoff.  The following post is from the blog by Rick Bookstaber who is a very well decorated author within the investment management industry.  Please feel free to leave your comments on this post below.

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The 7 Habits of Highly Suspicious Funds

Note: This post will appear in The Journal of Investment Management

You’ve heard this story before: A trader at a bank is knocking the cover off the ball. His success garners political power within the bank. He creates a fiefdom that insulates him from the rest of the firm; his trading group explodes in size. He lives a conspicuous, extravagant lifestyle. His ego alienates the management and intimidates the support staff. Then the trader hits a rough patch. He uses all the tricks in the book to keep his poor results under wraps while he tries to find a way to recoup. Everyone is gunning for him, so he has to get back into the black, and fast.

How does he try to do that? He ratchets up his risk. He knows he won’t be able to turn it around fast enough if he plays it prudently, whereas there is some chance to stay in the game if he bets it all on 00, or better yet, if he levers up as much as he can, borrows all the money he can get his hands on, and then bets all of that on 00. If he loses, well, he was going to be gone anyway, so he may as well try for the big time.

That is one of the reasons there are risk managers. Risk managers know to put extra focus on traders who are struggling and, for that matter, on traders who seem to have an eerily hot hand. Especially if those traders have the ability to lever and to obscure their risk through the use of sophisticated instruments.

This story is now primed to play out in the hedge fund space. How many hedge funds do you know that more or less fit this description: A hedge fund manager had a run of great returns. His fund has grown by leaps and bounds. He has doubled his staff year after year in anticipation of even greater things to come. He has enjoyed a Page Six lifestyle; he is the belle of the ball, his dance card always filled. But now his kingdom is under siege. Assets under management have dropped precipitously due to redemptions layered on top of poor trading results. The investors that remain are demanding reductions in management fees. Incentive fees are gone until he scales the wall to get back to high water mark. With the way his operation has ballooned, he realizes that if he doesn’t make serious returns over the next few years, he will be crushed under the costs and the dwindling asset base.

What does he do? If he follows the same course as the trader at the bank, he will try to find ways to take on more risk. Of course, any investment fund might face the same temptation, but hedge funds have more tools at their disposal to make good on the try. Hedge funds can lever, delve into wide-ranging and risky markets and readily employ the so-called innovative securities to increase risk in ways that are difficult to discern. And unlike the trader at the bank, the hedge fund can operate without anyone seeing what it is doing. No one is looking over its shoulder at the trading positions each night.

Is the risk management in place to deal with this scenario? Here are seven “habits” that an investor should look out for:

1. No independent risk reporting.

One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. Or, at least, trust but verify. If things go wrong and that is what you relied on, you will look like a fool, or worse. The risk numbers must come from having a third party getting the fund’s positions and doing the analysis.

The risk reporting must go beyond the VaR numbers to include measures of leverage, concentration, degree of diversification and size in markets (to assess liquidity risk). Again, all independently provided.

The diversification and concentration are necessary because, as we now know all too well, the relationships between markets can change. These risk measures cannot be calculated simply by knowing how many markets the fund is trading. It is critical to know how linked the markets are; how concentrated positions are when aggregated across similar markets. With globalization, diversification opportunities aren’t what they used to be. And in any case, it isn’t much value to be active in twenty markets if two-thirds of the positions are in three or four markets that are closely related.

2. A change for the worse in the critical risk numbers.

When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports? For example, is the third-party view of leverage, liquidity or diversification as favorable as has been represented by the fund itself, both now and historically?

3. Increased use of derivatives.

In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and difficulty in marking means that they also can more easily hide losses. There should be extra concern if the fund has only recently decided to start using derivatives and swaps.

4. High level of secrecy.

Does the fund have a monolithic, scripted presence to outside investors? Does it obscure its approach with secret formulas and strategies? Does it invoke its need for secrecy to justify limiting access to essential risk information and to its production staff? If so, you might want to get ready for a Madoff moment.

5. Growth in headcount and lifestyle.

This is the firm’s equivalent of the trader’s lifestyle. The fund’s principles can stretch the envelope in terms of personal lifestyle, and, unlike their banker cousins, their firm is their own domain. They can get an “edifice complex”. If a firm has become bloated, if it has a growing cost base that forces it to be impatient, then it will be more desperate to swing for the fences.

6. Decline in assets under management.

This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

Related to this, is the fund far below high water mark? Hedge funds make money from fixed management fees based on assets under management and incentive fees based on the return they generate for their clients. Most hedge funds only start collecting the incentive fees after they get back to high water mark. If a hedge fund is thirty percent below high water market, it may need years of strong returns before any money starts ringing up in the incentive fee register.

7. Lackluster performance in recent years.

Most everyone was lackluster this past year. So you should look back at the recent performance before the 2008 debacle. A comparison of the performance over the past three to five years versus the performance in the more distant past can be an indicator of a failure of the fund’s inherent strategy. It could be that the space has become too crowded and competitive, that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. If things have been slowly petering out, if alpha has been diminishing, then more leverage and risk is needed to get back up to the target.

Or, in desperation, the fund might try something new. So a related phenomenon will be style drift or a move into new markets and strategies. Style drift can be an indication that the bread and butter strategy is not pulling its weight. Is there movement toward new markets, a.k.a. ‘new opportunities’. Is an equity fund hiring expertise to gear up in credit, is a macro fund starting to trade volatility?

Not everyone standing in the shadows is a mugger. And sometimes a cigar is just a cigar. Although “habits” like a lack of independent reporting are pretty obvious weaknesses, others, such as exploring new trading strategies, might be justifiable. But these are warning signs that justify deeper questioning and tighter oversight.

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Please contact us if you have any questions on the above article.  Other related hedge fund law blog articles include:

Private Fund Transparency Act of 2009 Text of Statute

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Text of New Hedge Fund Registration Bill

Earlier we posted a press release about the Private Fund Transparency Act and that it would subject hedge fund managers to registration with the SEC.  Below is the actual text of the statute.

We will be bringing an in depth analysis of changes and consequences of this bill in the next couple of days.

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Private Fund Transparency Act of 2009 (Introduced in Senate)

S 1276 IS

111th CONGRESS

1st Session

S. 1276

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

June 16, 2009

Mr. REED introduced the following bill; which was read twice and referred to the Committee on Banking, Housing, and Urban Affairs

A BILL

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Transparency Act of 2009′.

SEC. 2. DEFINITION OF FOREIGN PRIVATE ADVISERS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

`(29) The term `foreign private adviser’ means any investment adviser who–

`(A) has no place of business in the United States;

`(B) during the preceding 12 months has had–

`(i) fewer than 15 clients in the United States; and

`(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

`(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS.

Section 203(b)(3) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)(3)) is amended to read as follows:

`(3) any investment adviser that is a foreign private adviser;’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA; ANNUAL AND OTHER REPORTS.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended–

(1) in subsection (a), by adding at the end the following: `The Commission is authorized to require any investment adviser registered under this title to maintain such records and submit such reports as are necessary or appropriate in the public interest for the supervision of systemic risk by any Federal department or agency, and to provide or make available to such department or agency those reports or records or the information contained therein. The records of any company that, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, would be an investment company, to which any such investment adviser provides investment advice, shall be deemed to be the records of the investment adviser if such company is sponsored by the investment adviser or any affiliated person of the investment adviser or the investment adviser or any affiliated person of the investment adviser acts as underwriter, distributor, placement agent, finder, or in a similar capacity for such company.’; and

(2) adding at the end the following:

`(d) Confidentiality of Reports- Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (a). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.’.

SEC. 5. ELIMINATION OF PROVISION.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 6. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended–

(1) by striking the second sentence; and

(2) by striking the period at the end of the first sentence and inserting the following: `, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

`(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

`(2) ascribe different meanings to terms (including the term `client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.’.

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Other related articles:

Obama’s New Hedge Fund Regulation Plan

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Draft Speaks of IA Registration for Hedge Fund Managers

As you have probably heard by now, Obama will be presenting his plan for an overhaul of the financial system later today.  I have reviewed a copy of Obama’s Financial Regulation Proposal Draft and have reprinted some of the important aspects of the proposal below.  In general the most immediate impact for hedge fund managers is that they will be required to register with the SEC as investment advisors.  In addition to hedge fund managers, private equity fund managers and VC fund managers will also need to register.

While we understand that these are just proposals, Congress too is excited to get on the registration bandwagon although I think it unlikely for us to see any regulation passed before the end of this year.  Even so, hedge fund managers may want to start thinking about how they are going to register as investment advisors and what plans they will need to be putting in place (or plan to put in place in the future).

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The plan’s main goals are:

  1. Promote robust supervision and regulation of financial firms.
  2. Establish comprehensive supervision and regulation of financial markets.
  3. Propose comprehensive regulation of all OTC derivatives.
  4. Protect customers and investors from financial abuse.
  5. Raise international regulatory standards and improve international cooperation.

Other Points Addressed

Regarding Hedge Funds

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act.  The advisers should be required to report financial information on the funds they manageme that is sufficient to assess whether any fund poses a threat to fiancnail stability.

Harmonize Futures and Securities Regulation

The CFTC and the SEC should make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities.

Strengthen Investor Protection

The SEC should be given new toold to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers.

Expand the Scope of Regulation

We urge national authorities to implement by the end of 2009 the G-20 commitment to require hedge funds or their managers to register and disclose appropriate information necessary to assess the systemic risk they pose individually or collectively.

Specifical goals with regard to Hedge Funds

  • Data collection
  • SEC should conduct regular, periodic examinations of hedge funds
  • Reporting AUM and other fund metrics to the SEC
  • SEC would have ability to assess whether the fund or fund family is so large, highly leveraged , or interconnected that it poses a threat to fiancial stability

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

NASAA Applauds Obama’s Recent Directive on State Agency Preemption

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President of the NASAA Sends Letter to President Obama in Support of Limiting Preemption of State Regulation

In a letter dated June 9th, 2009, Fred Joseph, President of the North American Securities Administration (NASAA), applauded President Obama  for his efforts to control preemption of state law in the area of securities regulation.

On May 20th, President Obama issued a directive setting limits on regulatory preemption of state regulation, largely in an effort to expand the authority of state regulatory officials to regulate many aspects of the securities markets and detect potential misconduct.

In his letter, Joseph writes that despite the proven century-long track record of investor protection by state securities regulators,  Congress has still passed legislation over the years that has preempted state regulation and curtailed the authority of state officials in protecting both investors and consumers.

Joseph writes,

” Federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law.”

To further address what many regard as the most urgently needed reform, the NASAA endorses the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limited the accumulation of risk in the financial markets.

The entire text of letter by the NASAA to President Obama is included below, and can also be found here.

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NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.
750 First Street, NE, Suite 1140
Washington, D.C. 20002
202/737-0900
Fax: 202/783-3571
www.nasaa.org

June 9, 2009

President Barack Obama
The White House
1600 Pennsylvania Avenue NW
Washington, DC 20500

Dear Mr. President:

On behalf of our nation’s state securities regulators, the North American Securities Administrators Association1 applauds your effort to reverse the anti-investor preemption policies of previous administrations.

Your May 20 directive setting limits on regulatory preemption impressively affirms the vital role that state regulators play in protecting the health, safety, and financial security of citizens throughout the United States. You have sent a strong signal that our nation’s citizens are served best when the state-federal partnership works harmoniously and with mutual respect to “provide independent safeguards for the public.” Furthermore, we sincerely appreciate your recognition that states have frequently been more aggressive than the national government in protecting the public’s interest.

In the area of securities regulation, the states have a century-long track record of investor protection. One of the hallmarks of state securities regulation is its proven ability to detect misconduct, both large and small, in the early stages. Our members enjoy a unique proximity to investors and to the industry participants within their state borders. As a result, state securities regulators are often the first to investigate and uncover our nation’s latest and most damaging frauds. Examples include investigating the role of investment banks in the Enron fraud, exposing profound conflicts of interest among Wall Street stock analysts, addressing late trading and market timing in mutual funds, and recently helping to ensure that investors receive over $50 billion in redemptions for frozen auction rate securities that had been marketed as safe and liquid investments.

And yet, over a number of years, there has been a concerted effort to preempt state regulation. In the securities field, much of that effort has originated in Congress. For example, in 1996, Congress passed the National Securities Markets Improvement Act (NSMIA), which dramatically curtailed the authority of our members to regulate many aspects of the securities markets, ranging from private offerings under Regulation D to investment advisers with over $25 million in assets under management.

As your recent order recognizes, federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law. Two striking examples are found in the banking area.

The Office of the Comptroller of the Currency (OCC) has repeatedly adopted regulations that aggressively preempt the states’ authority to protect consumers through licensing requirements or enforcement actions. The impact has been felt largely in the mortgage lending field—where illegal underwriting practices helped trigger the current financial crisis. In a case now pending before the U.S.

1 NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.

Supreme Court, the Second Circuit aptly characterized the OCC as an agency that “accretes a great deal of regulatory authority to itself at the expense of the states through rulemaking lacking any real intellectual rigor or depth.” Clearing House Ass’n, L.L.C. v. Cuomo, 510 F.3d 105,119 (2d Cir. 2007) (although upholding the OCC’s limits on state visitorial powers under binding precedent). In the Cuomo case, the OCC actually sought an injunction to prevent the New York Attorney General’s Office from investigating discriminatory lending practices by various national banks and their operating subsidiaries.

The Office of Thrift Supervision (OTS) has also issued broadly preemptive regulations. Relying on those rules, the OTS has taken the position that even independent agents used by thrift institutions to market mortgages or certificates of deposit are immune from all substantive state regulations aimed a protecting consumers. The OTS’s opinion was articulated in an October 25, 2004 opinion letter. The OTS position has a direct impact on our members, to the extent it authorizes thrifts to market securities products, such as jumbo CDs, without complying with the licensing requirements applicable under state securities laws.

These examples and others affirm the need not only to rein in, but also to reverse, instances of state law preemption. An important corollary is making sure that the states are adequately represented in any regulatory reforms that your administration and Congress may fashion to address our current economic crisis. Plainly, our system of financial services regulation must be more effective. The enormous challenge of regulating our financial markets can only be met through the combined efforts of state and federal regulators, working together to protect both investors and the integrity of the marketplace. Any regulatory reforms should incorporate this guiding principle.

For that reason, to address what many regard as the most urgently needed reform, we endorse the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limiting the accumulation of risk in our financial markets. With our unique position on the frontlines of investor protection, state regulators are essential to the success of any remedy aimed at controlling systemic risk. We provide ground-level detection by gathering a huge volume of information through examinations of industry participants and complaints from investors. When that information reveals risks and abuses, we take appropriate action. The Council approach, with full state representation, takes advantage of these strengths. We would ask that you carefully evaluate the benefits of this model as you weigh alternative solutions to the difficult problem of systemic risk.

NASAA is committed to working with your Administration and the 111th Congress to ensure that the nation’s financial services regulatory structure undergoes the important changes that are necessary to enhance protections for Main Street investors. Your recent directive on agency preemption is a very important step, and as you move forward with other regulatory reforms, we hope you will continue to recognize the enormous value of state regulation in our system of federalism.

Sincerely,

Fred Joseph
President North American Securities Administrators Association
Colorado Securities Commissioner

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Hedge Fund Adviser Registration Act of 2009

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Congressional Bill Proposed in House

In January we gave significant attention to the Hedge Fund Transparency Act of 2009 and we did not focus at all on a similar bill introduced in the House of Representatives.   The Hedge Fund Adviser Registration Act of 2009, introduced on January 27, would change the Investment Advisers Act of 1940 to require those managers with more than $30 million in assets to register as investment advisors with the SEC (for background, please see 203(b)(3) exemption).  The Hedge Fund Transparency Act takes a decidedly different route to regulation – it would require hedge fund managers, under the Investment Company Act of 1940 , to register as investment advisors and it would also require hedge funds to submit certain information to the SEC.

The fate of both of these bills is currently in question.  It seems as though Congress and the SEC are waiting for President Obama and Treasury Secretary Geithner to develop a plan for a comprehensive regulatory system.  While we remain in this holding pattern it seems likely that any regulatory changes are months and months away.

The full text of the Registration Act are reprinted below along with a press release announcing the proposed measure.  Other related hedge fund law articles include:

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Hedge Fund Adviser Registration Act of 2009 (Introduced in House)

HR 711 IH

111th CONGRESS

1st Session

H. R. 711

To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.

IN THE HOUSE OF REPRESENTATIVES

January 27, 2009

Mr. CAPUANO (for himself and Mr. CASTLE) introduced the following bill; which was referred to the Committee on Financial Services

A BILL

To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Hedge Fund Adviser Registration Act of 2009′.

SEC. 2. REMOVAL OF THE PRIVATE ADVISOR EXEMPTION.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by striking subsection (b)(3).

Source

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PRESS RELEASE

Capuano, Castle Bill Would Improve Oversight of Hedge Funds

Requires money managers to register with SEC

January 27, 2009

Washington, DC — Today, Reps. Mike Castle (R-DE) and Mike Capuano (D-MA), introduced bipartisan legislation that is intended to close a loophole created in the Investment Advisors Act of 1940, which exempts hedge fund managers from registering with the Securities and Exchange Commission (SEC) if they have less than 15 clients. The Hedge Fund Managers Registration Act, would require anyone who manages hedge funds to register with the SEC, and therefore improves federal oversight of these investments.

“This measure would require all hedge fund managers to register with the SEC so that their actions on behalf of investors are transparent,” said Rep. Capuano. “I have long advocated this simple step as a way to better understand how hedge fund managers are operating, and how they are investing the resources of their clients. In addition to providing us with basic census information on hedge funds, this measure can be used to detect and deter fraudulent practices and risky behavior before it’s too late.”

“Hedge funds are a $1.5 trillion industry that account for roughly 30 percent of U.S. stock trading, but also have tremendous presence in other areas of our markets. Without greater attention and oversight to protect investors from fraud, hedge funds pose systemic risk to our economy,” said Rep. Castle, senior member on the House Financial Services Committee. “As we work to help regain our economic health, I believe we can and should scrutinize money managers more carefully and begin to reclaim some order in equity markets. I am hopeful that this legislation will work as a tool to help protect investors from becoming victims. This is the first in a series of reforms I intend to strongly advocate in the coming months.”

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Contact: Alison M. Mills (617) 621-6208
Contact: Stephanie Fitzpatrick (202) 225-4165 (Rep. Castle)

New Hedge Fund Laws Proposed in Connecticut

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State to Increase Regulation of Hedge Funds

(www.hedgefundlawblog.com)  Connecticut, home of many of the biggest hedge funds in the world, may begin regulating hedge funds in a heavy handed manner.  Recently state lawmakers have introduced three bills (Raised Bill No. 953, Raised Bill No. 6477 and Raised Bill No. 6480) which would greatly increase oversight of hedge funds which have a presence in Connecticut.   This article provides an overview of the three raised bills and provides reprints the actual text of these bills.

Raised Bill No. 953

The largest of the three bills, No. 953 has the following central features:

  • Definitions certain terms (including the term “Hedge Fund”) which are used throughout the bill.
  • Provides that, starting in 2011, hedge funds may not have individual investors  who do not have $2.5 million in “investment assets” (different than net worth)
  • Provides that, starting in 2011, hedge funds may not have institutional investors who do not have $5 million in “investment assets”
  • Provides that funds must disclose certain conflicts of interest of the manager
  • Provides that funds must disclose the existence of side letters
  • Requires an annual audit (beginning in 2010)

The above provisions would apply to those funds which have an office in Connecticut where employees regularly conduct business on behalf of the fund.   It is currently unclear whether there will be any sort of grandfathering provisions for those funds which currently have investors who do  not meet the “investment assets” threshold.   Another interesting part of the bill is that it defines a hedge fund with reference to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.  The recently proposed Hedge Fund Transparency Act would actually eliminate these sections and add new Section 6(a)(6) and Section 6(a)(7).

Raised Bill No. 6477

The next bill is No. 6477 which would require hedge funds to be regulated by the Connecticut Banking Commission.  The bill requires hedge funds to purchase a $500 license issued by the Connecticut Banking Commissioner prior to conducting business in Connecticut.  The license would need to be purchased each year.  The bill also provides the Banking Commission with authority to adopt regulations.

This bill is interesting because it is fundamentally different from most hedge fund regulations which seek to regulate the management company through investment advisor registration.  This bill regulates the fund entity (as opposed to the management company) and does so through the power of the state to regulate banking.   Right now it looks like this bill will apply to all hedge funds, even those who do not utilize leverage.  It is not currently clear why or how the Banking Commission has jurisdiction non-banking private pools of capital, especially for those funds which do not utilize any sort of leverage.

It is also interesting to note that No. 6477 would apply regardless of the registration status of the fund’s management company.  This means that a fund could be subject to SEC oversight and may also be subject to direct oversight by the Connecticut Department of Banking (“DOB”), which means the DOB could presumably conduct audits of the fund.  Of course, this could potentially greatly increase operational costs for hedge funds with an office in Connecticut.

Raised Bill No. 6480

The final bill is No. 6480 which would require Connecticut based hedge funds with Connecticut pension fund investors to disclose detailed portfolio information to such pension funds upon request.  It goes without saying that this bill is likely to receive a considerable amount of scrutiny from the Connecticut hedge fund community.

Conclusion

The hedge fund industry continues to be a major focus of both state and federal lawmakers who are anxious to start regulating these vehicles.  Unfortunately we are witnessing a patchwork approach to regulation where there is little communication between the states and the federal lawmakers.  If other states follow Connecticut’s lead then we face the potential situation where funds in each state will need to follow state specific laws enacted by quick-to-legislate, out-of-touch lawmakers.   Efficiency in the securities markets is undercut by overlapping and unnecessary regulations – both managers and investors would be better served by a comprehensive effort to revise the securities laws at the federal and state levels.

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Raised Bill No. 953
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING HEDGE FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) As used in this section:

(1) “Hedge fund” means any investment company, as defined in Section 3(a)(1) of the Investment Company Act of 1940, located in this state (A) that claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940; (B) whose offering of securities is exempt under the private offering safe harbor criteria in Rule 506 of Regulation D of the Securities Act; and (C) that meets any other criteria as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section. A hedge fund is located in this state if such fund has an office in Connecticut where employees regularly conduct business on behalf of the hedge fund;

(2) “Institutional investor” means an investor other than an individual investor including, but not limited to, a bank, savings and loan association, registered broker, dealer, investment company, licensed small business investment company, corporation or any other legal entity;

(3) “Investment assets” includes any security, real estate held for investment purposes, bank deposits, cash and cash equivalents, commodity interests held for investment purposes and such other forms of investment assets as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section;

(4) “Investor” means any holder of record of a class of equity security in a hedge fund;

(5) “Major litigation” means any legal proceeding in which the hedge fund is a party which if decided adversely against the hedge fund would require such fund to make material future expenditures or have a material adverse impact on the hedge fund’s financial position;

(6) “Manager” means an individual located in this state who has direct and personal responsibility for the operation and management of a hedge fund; and

(7) “Material” means, with respect to future expenditures or adverse impact on the hedge fund’s financial position, more than one per cent of the assets of the hedge fund.

(b) On or after January 1, 2011, no hedge fund shall consist of individual investors who, individually or jointly with a spouse, have less than two million five hundred thousand dollars in investment assets or institutional investors that have less than five million dollars in assets.

(c) The manager shall disclose to each investor or prospective investor in a hedge fund, not later than thirty days before any investment in the hedge fund, any financial or other interests the manager may have that conflict with or are likely to impair, the manager’s duties and responsibilities to the fund or its investors.

(d) The manager shall disclose, in writing, to each investor in a hedge fund (1) any material change in the investment strategy and philosophy of the fund and the departure of any individual employed by such fund who exercises significant control over the investment strategy or operation of the fund, (2) the existence of any side letters provided to investors in the fund, and (3) any major litigation involving the fund or governmental investigation of the fund.

(e) On January 1, 2010, and annually thereafter, the manager shall disclose, in writing, to each investor in a hedge fund (1) the fee schedule to be paid by the hedge fund including, but not limited to, management fees, brokerage fees and trading fees, and (2) a financial statement indicating the investor’s capital balance that has been audited by an independent auditing firm.

(f) The Banking Commissioner may adopt regulations, in accordance with chapter 54 of the general statutes, to implement the provisions of this section.\

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Raised Bill No. 6477
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING THE LICENSING OF HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) No person shall establish or conduct business in this state as a hedge fund or private capital fund without a license issued by the Banking Commissioner. Applicants for such license shall apply to the Department of Banking on forms prescribed by the commissioner. Each application shall be accompanied by a fee of five hundred dollars. Such license shall be valid for one year and may be renewed upon payment of a fee of five hundred dollars and in accordance with the regulations adopted pursuant to subsection (b) of this section.

(b) The Banking Commissioner shall adopt regulations in accordance with the provisions of chapter 54 of the general statutes for purposes of this section.

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Raised Bill No. 6480
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT REQUIRING THE DISCLOSURE OF FINANCIAL INFORMATION TO PROSPECTIVE INVESTORS IN HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) Any hedge fund or private capital fund that is (1) domiciled in the state, and (2) receiving money from pension funds domiciled in the state shall disclose to each prospective pension investor in such funds, upon request, financial information including, but not limited to, detailed portfolio information relative to the assets and liabilities of such funds.