WASHINGTON -- The Securities and Exchange Commission should consider setting reasonable limits on the ability of tax-exempt money market funds to invest in some synthetic variable-rate demand notes, SEC member Richard Roberts was expected to say late yesterday at a treasurers' conference.
But in his first speech on the subject of tax-exempt derivative products, Mr. Roberts was also expected to say that many of the issues surrounding another popular derivative, interest rate swaps, should be left up to the market and issuers rather than federal regulators.
According to a draft of the speech, to be delivered last night at the Midwest State Treasurers' Conference in Minneapolis, Mr. Roberts did, however, strongly caution issuers to "exercise care and be sure that the swap is designed properly" so the risks of issuing the bonds do not outweigh the benefits.
"Synthetic variable-rate demand notes have complex structures," the draft speech says. "A credit risk probably exists with respect to each of the put providers involved in the arrangement."
A variable-rate demand note is a bond with a seven-day put that changes its rate every seven days. A synthetic variable-rate demand note is an outstanding long-term fixed-rate bond to which a put with a variable rate is attached.
The speech says some of the risks associated with puts can be alleviated by the way they are structured for tax purposes. But the SEC, it adds, should "strongly" weigh placing limits on funds investing in some synthetics "which possess higher credit risks due to their complexity."
The SEC last year set new diversification and quality standards for managers of taxable money market fund portfolios and was expected by year's end to propose restrictions for tax-exempt funds, which are major buyers of variable-rate demand notes. But the move to revise the SEC's Rule 2a-7 governing those standards has been put on the back burner because of the November elections and President Bush's moratorium on new regulations.
Mr. Roberts was expected to say he is disappointed that the commission has not acted, noting that there are about 180 tax-exempt money market funds with approximately $93.2 billion in assets. "These funds are too large to be ignored in a regulatory sense," his speech says, noting that 41% of tax-exempt funds hold, or have at some time invested in, synthetic securities.
Turning to interest rate swaps, Mr. Roberts was to say that under the right circumstances, these derivatives "can be an effective instrument for state and local debt management programs."
Interest rate swaps are contracts between two parties, such as an issuer and a bank, to exchange interest payments for a specified period. In effect, they allow an issuer to pay floating rates on fixed-rate debt or fixed rates on variable-rate debt.
However, the speech warns issuers to consider several factors when putting together a swap deal. They include the certainty of legal authority, the counterparty risk, the leveraging involved, the length of the swap, the index used, the compensation paid to the counterparty, the break-even point, the ability to obtain comparable market quotes, and the political problems posed in the event of unanticipated payments under a swap agreement.
"I suspect that these are considerations more appropriate for the market and government issuers," Mr. Roberts' speech adds, "rather than for federal securities regulators."
But in general, the speech says, derivatives are so complex that "there should be more intense scrutiny" by the SEC. "It is not that derivative or synthetic securities are per se evil so much as that regulators do not at present fully understand the risks they pose."
"Hopefully, the commission will ultimately become more comfortable with these new financial products," Mr. Roberts was expected to say. "I am unaware of anyone at the commission who is interested in stifling innovative financial engineering."
In an effort to close the learning gap, the speech notes, the SEC staff will be collecting extensive information on taxable and tax-exempt derivatives from the industry under a one-month-old rule requiring securities firms to report their holdings. The temporary rule takes effect Sept. 30 and expires at the end of 1994, when the SEC is to decide whether to make it permanent.
Derivatives have avoided the scrutiny of the SEC and other regulators because the products are generally traded through holding companies and affiliates of broker-dealers, rather than by the broker-dealers themselves. Broker-dealers must register with the agency and report regularly on the volume and type of securities they hold, but their holding companies and affiliates generally do not have to.
Lee Barba, managing director of BT Securities Corp. in New York, said the speech raised valid points, but additional regulation is not required. "This is an established market," said the chairman of the Public Securities Association's municipal derivatives committee, who said he was not necessarily speaking for the group.
"Synthetic VRDNs have been around since 1983. And it's a market of substantial size and sophistication," he said. Moreover, he said, the market does differentiate on the basis of the quality of the credit and the put provider and a program's structure.