Procter & Gamble, J.P. Morgan, General Electric, Gibson Greeting, Cargill. Each company has reported a surprising financial loss from derivatives trading. Each company's loss stemmed purely from over-the-counter interest rate derivatives.
According to the financial media, these unsettling developments have spurred many corporations to reassess their strategies for interest rate risk management. Chief executives and financial officers are reevaluating the price, liquidity, and credit risk they have assumed in the OTC derivatives markets.
As a result, derivatives have become - for better or worse something of a household name in the financial media, building momentum for Congress, the Commodity Futures Trading Commission, and other regulators to focus on this issue.
A recent report by the General Accounting Office said that derivatives regulation today is marked by inconsistencies and disparities. While gaps and weaknesses exist at the OTC level, the GAO found that exchange-traded derivatives are comprehensively regulated.
Unequal Treatment
The CFTC policies and interpretations are major contributors to this disparity in regulatory treatment.
For example, the CFTC interprets the statute it is charged with administering, the Commodity Exchange Act, to permit OTC dealers to copy the Chicago Board of Trade's heavily regulated Treasury bond futures contract, offer it to the same institutions and professionals that account for 98% of the CBOT's customer base, and escape all federal regulation.
Such an interpretation is tantamount to having the Federal Election Commission decide that its campaign finance restrictions would apply only to Democrats, but not Republicans, or vice versa.
Similar clear evidence of the disparate treatment between over-the-counter and exchange markets is in the area of CFTC exemptions. In 1992, Congress granted the CFTC power to exempt both OTC and exchange instruments from any and virtually all federal requirements.
Pleas for Exemption Ignored
Congress told the CFTC to use that new power to "promote fair competition" in a "fair and evenhanded manner" for OTC and exchange-traded instruments alike.
Despite that legal mandate, the CFTC still has not-responded to exchange petitions for exemptive relief for products nearly identical to those offered over the counter.
Yet, within three months of getting its new authority, the CFTC did grant OTC swaps an almost total exemption from CFTC regulation, and within six months the agency granted an even broader exemption for OTC energy contracts.
The more modest exchange exemptive request, our ProMarket petition, will soon celebrate its one-year anniversary at the CFTC. That ProMarket proposal would streamline existing regulation for new products that only "professional traders" are allowed to trade.
In addition, important information about pricing, market liquidity, and position valuation would be available through the ProMarket - the very issues of concern identified in recent studies of the OTC markets. No date for final action on our petition is on the horizon. That does not seem fair.
Good Public Policy
Exempting "professionals only" exchange market innovations is good public policy. ExChange markets rely on a time-tested system of self-regulation to provide price transparency, market integrity, and financial safety. The OTC markets have no such safeguards.
Given these facts, the CFTC's approach to its exemptive authority seems to be backward.
The GAO report repeats one common misperception often cited to justify why exchange instruments are regulated while OTC instruments are not. According to that theory, exchanges trade standardized products, while OTC markets offer customized instruments.
That simplistic distinction, however, is unsupported by the realities of today's markets.
"Plain-vanilla" swaps are traded over the counter without any regulation. Those instruments are, according to Rep. Larry Combest of Texas, "economically indistinguishable from futures contracts traded on CFTC-designated exchanges."
At the same time, exchanges are developing customized instruments. The board of trade's new flexible bond options have been trading since January, with considerable success.
Many market participants like this new contract because they can customize their options to fit their risk management needs and still enjoy the price transparency and clearing provided for exchange-trading, protections that are absent from OTC trading.
What those market participants do not like about flex options is the high level of regulatory cost they face in contrast to OTC offerings. The ProMarket petition, if approved, could cure that disparity.
For years, the Chicago Board of Trade balked at competing with OTC derivatives and urged that the same regulatory burdens we face should be imposed on OTC markets. Today, we are more enlightened. We believe OTC markets are as important to world commerce as the exchange markets.
Each brings unique benefits to our economy. Each deserves appropriate regulatory treatment that gives due regard to private market self-policing. Today, OTC derivatives enjoy such treatment. If ProMarket is adopted, exchanges would too.
Mr. Arbor is chairman of the Chicago Board of Trade.
