Swap New For Old: Congress Shouldn’t Impose Tired Rules On OTC Derivatives — Sheehan in IBD

Published in Investor’s Business Daily

August 9, 2000

America's continued financial leadership in the new economy is at stake as Congress sets out to modernize the Commodity Exchange Act, the law that covers futures and derivatives trading. The revised law is supposed to liberalize the derivatives market, setting important legal terms that distinguish traditional commodity futures from over-the-counter derivatives, or swaps. The future of the U.S. swaps market depends on whether Congress can keep it free of entangling regulations and legal uncertainty.

Derivatives are an essential tool of risk management for American businesses. They are the lubricants that let financial markets allocate capital more efficiently. Foreign exchange swaps, for example, diminish the risks associated with fluctuating currencies. Rate swaps smooth out the effects of interest-rate fluctuations by converting long-term, fixed-rate debt into short-term, variable-rate debt. OTC derivatives make businesses more competitive by lowering their cost of capital.

To be effective, the enforceability and legal status of swaps must be firmly established. Banks and other financial institutions have worried for years that the Commodity Futures Trading Commission might begin applying futures regulations to swaps. That would be disastrous, since futures contracts are legally enforceable only if they are traded on a listed exchange, such as the Chicago Mercantile Exchange. Off-exchange swaps are privately negotiated, custom-tailored contracts.

Trillions of dollars in interest-rate and currency-swap contracts would be undermined if they were suddenly regulated like futures. Banks furnishing swaps to large institutional and corporate clients are poised to extend the benefits of these risk management tools to their small business and retail customers. But they are wary of the CFTC, which in 1998 considered regulating swaps. The legal uncertainty this created was unsettling to the financial markets, which don't consider the CFTC technically competent to regulate complex swap transactions. Unwarranted bureaucratic restrictions would reduce the technical precision of swaps and increase their cost.

House bill H.R. 4541, the Commodity Futures Modernization Act, is supposed to rationalize the regulatory environment and provide legal certainty. But this effort is fragmented because of the competing jurisdictions of regulatory agencies and congressional committees. An amendment recently offered by House Banking Committee Chairman Jim Leach, R-Iowa, goes the furthest in liberalizing OTC swaps, but still leaves room for regulatory meddling. Though the CFTC couldn't regulate them, the Treasury Department or Federal Reserve could.

Other versions of H.R. 4541 set up a convoluted series of exemptions to insulate most swaps from CFTC regulation, but don't exempt the entire universe of swaps. Individual investors worth less than $5 million to $10 million in assets will likely face regulatory hurdles. Ostensibly these restrictions are meant to protect retail investors from fraud. However, as Harvard University law professor Hal Scott testified to the House Banking Committee, the true purpose might be "to fence off exchange-traded derivatives markets from competition with OTC derivatives markets for retail investors."

Swap contracts completed over electronic trading facilities are potentially vulnerable under the bill. Specifically, derivative transactions resulting from "automated trade matching algorithms" are exposed to additional regulation. This language could inhibit the new economy innovators that match trades electronically using highly specialized software.

The big commodity exchanges would benefit from rules that hinder off-exchange innovators. But the added red tape will only delay the inevitable. If regulatory barriers are set up to protect the futures industry from electronic competition, the innovators will simply move offshore. If Congress wishes to liberalize swaps, it should do so by defining commodity futures narrowly and prohibiting any regulation of OTC derivatives outside the definition. Over-the-counter swaps should be completely exempt from antiquated exchange rules that were designed for the old economy. Rather than leaving any OTC derivatives in regulatory limbo, Congress should confer ironclad legal certainty upon all kinds of swaps. 

James M. Sheehan is an adjunct scholar of the Competitive Enterprise Institute in Washington, D.C.