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Not only is the SEC overhauling its internal processes and procedures under new chairman Mary Schapiro, it also is taking steps to establish potential regulation in four major areas: the over-the-counter derivatives market, short selling, dark pools and sponsored access to exchanges. Advanced Trading examines these four areas, offering a quick overview of the issues and insight into what action the SEC might take, as well as commentary from Larry Tabb, founder and CEO of financial markets research and advisory firm TABB Group.
The OTC Derivatives Market
THE ISSUE:
The SEC and Treasury Secretary Timothy Geithner have said that potential regulation of the OTC derivatives market would include 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, and enforcement against fraud and other wrongdoing.
WHAT THE SEC SAYS:
At a Senate hearing before the Subcommittee on Securities, Insurance and Investment and the Committee on Banking, Housing and Urban Affairs, SEC chairman Schapiro said, "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."
Schapiro added, "One important aspect of a new regulatory framework will be well-regulated central counterparties. CCPs address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. ... [But] achieving standardization, a prerequisite for centralized clearing, may present significant challenges."
Oversight of the OTC derivatives space would be divided between the SEC and the Commodity Futures Trading Commission (CFTC), according to Schapiro. The SEC would be responsible for oversight of "securities-related" OTC derivatives, while the CFTC would oversee derivatives related to interest rates, foreign exchange, commodities, energy and metals.
The new regulatory framework would be brought under the same umbrella of oversight as the related, underlying securities markets, said Schapiro. "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," she explained.
Key highlights of the framework include definition of securities-related OTC derivatives, regulation of OTC derivatives dealers and major OTC participants, and regulation of trading markets and clearing agencies for securities-related OTC derivatives.
THE TABB VIEWPOINT:
"There's a lot of proposed regulation around OTC derivatives, and not necessarily all of it is SEC-related. But regardless of who is going to be [doing the] regulating, it should be consistent," says Tabb.
He explains that while the SEC wants to centrally clear OTC derivatives, this might be naive. "Central clearing revolves around valuation and liquidity -- [when there's] not enough liquidity, they can't value it, and they can't liquidate the positions in case a counterparty becomes insolvent," notes Tabb. "Only a limited set of these OTC products will end up being centrally cleared."
While the regulators haven't outright said that they are trying to migrate as much of the OTC derivatives market as possible onto exchanges, Tabb believes this is the underlying intention. "To migrate these products onto an exchange," he says, "will take a significant realignment of the contract."
