Q: During the past two weeks in Washington, derivatives have been called evrything from "a form of gambling"to "an important risk management tool." What's your view?
A: My own view is that derivatives are an important risk management tool. We've had an order of magnitude of advance in the sophistication of the management of risks due to derivatives technology. That's not to say that there does not need to be rules of the game as to how derivatives are used and and how their use is disclosed.
Q: What about those who warn derivatives could be the next savings and loan crisis"
A: I just think it's too simplistic a view. It's interesting to me that if you took a manufacturing business, certainly one that was international in scope and had a significant reliance on capital markets and raw materials markets, you would call them imprudent if they did not hedge their risk in the currency markets, in the interest rate markets, in the raw material markets. However, I find it somewhat perplexing that, to some folks in Washington, if [Employee Retirement Income Security Act] pension funds or mutual funds use these instruments to hedge and to manage risks. they're being speculative.
Q: But derivatives can be, and in some cases are, used for speculative purposes.
A: Exactly. But that's the level that the debate has to get to. There needs to be a greater understanding as to when and how derivatives are used to manage and mitigate risks, and when they're being used for leveraged speculation.
Q: Credit rating agencies say it's sometimes difficult to distinguish between speculative and non-speculative activities. Do you agree and does this pose difficulties for regulators?
A: Yes. Absolutely. One of the very significant challenges confronting the SEC over the next year is to create better disclosure so that investors can understand how derivatives are being used.
Q: What is needed?
A: We need to make disclosure a little more user-friendly. Right now, the generic disclosure for derivatives, if you take a look at a mutual fund prospectus, for example, is so encompassing. It covers every possible strategy from both a risk-mitigating standpoint and a speculation standpoint. That is disclosure by lawyers for lawyers. It's meant to be more of a disclaimer document.
We need to get a prospectus that has more useful information so that somebody can take a look and see if derivatives are being used specifically to enhance yield and to possibly increase the risk profile of that fund.
It's also incumbent on us to try to work toward better disclosure with regard to risk-adjusted returns. The idea is that you're a more informed investor if you're taking a look at a risk-adjusted return as opposed to just an absolute return.
On the surface, you may look at one money market mutual fund that yields 3.5% and one that yields 3.8%.
From an absolute standpoint, the 3.8% yield looks better. But when you see one fund is all in very short-term paper and the other is in instruments such as inverse floaters and other types of financially engineered paper ... on a risk-adjusted basis that 3.5% return might look better.
Q: Is this an area where we might see some new SEC rules?
A: When we had our commission meeting last spring and we adopted new regulations for mutual fund prospectuses, I stressed that I would like to see if we could find a way to move toward risk-adjusted returns.
We're encouraged by some of the voluntary efforts out there in the industry. And we will watch them closely to see if there is a standardized way that might develop in the marketplace that we might be able to mandate for risk-adjusted returns. It's not clear that we're there right now, but it certainly is encouraging to see some of the activities in the marketplace.
Q: A Standard and Poor's ratings group official testified recently that the SECS disclosure standards are not up to par with the banking agenies' standards and do not fully convey the risk profile of a firm in derivatives.
A: I would agree. I think that given the extensive use of derivatives now by a large number of public companies in managing their business and also among pension funds and mutual funds, it's much tougher to take a look at a balance sheet and ascertain the financial health of that company.
The nature of derivatives is that the risk is, in large part, off-balance sheet. What you're talking about with derivatives is contingent risk. That type of information is not now required to be on-balance sheet. So for the first time in recent history you can't look at a balance sheet and get a good handle on the financial health of the company if it has significant derivatives activities.
The Financial Accounting Standards Board clearly recognizes this deficiency and is working on better accounting disclosure for the use of derivatives. That's something that we, at the SEC, are strongly encouraging and helping to expedite in any way that we potentially can.
Q: You've called on the industry to adopt voluntary guidelines. What would you like to see?
A: Standardized accounting which will create much more transparency. My fear is that if the industry doesn't voluntarily move ahead, Congress will. There's a specific recommendation in the Group of Thirty's report that spells out what's needed ... Recommendation #24.
Q: And you support that?
A: Oh, very strongly. I thought the G-report 30 was a very good effort on behalf of the derivatives industry to try to proactively address some of these problems.
To me, the two most important recommendations of the G-30 report were the first and last. The first was that senior management must understand the risks that are being assumed by their business. I'd go even further and say not just senior management, but boards and, particularly, board audit committees.
Derivatives are business contracts between two parties that need to get marked to market every day. It's incumbent upon the board audit committees to make sure that the valuation process is taking place in a correct manner. Senior management and the boards must be sure that, if derivatives are used in a material way in their business, they are comfortable they have the right risk management systems in place.
They must be comfortable that their internal and their external auditors are asking the right questions regarding the valuation methods being used. They not only need to have a third-party group marking to market the trades, they also must make sure that the group is not relying upon the trading desk for key information for the valuation models they are using.
Q: Do you see the SEC doing anything in this area?
A: We can take more action. We oversee the accounting process. We clearly are working closely with the FASB in this area and do feel that there is a sense of urgency with regard to this process. We have delegated the authority to the FASB but we certainly will continue to work closely with them.
Q: You have been saving "the cops are on the beat " and that the SEC has the tools to oversee the derivatives market. What is the SEC doing?
A. One of the questions that came u in the House Banking Committee hearing is: "Why aren't you asking for legislation to give you more authority in this area?"
The answer is, we were given more authority with the Market Reform Act of 1990, under which our risk assessment program was created. We are now in the middle of this program and we have now received confidential information on the derivatives activities of over 250 broker-dealers with over 700 significant affiliates. So for the first time we are able to see beyond the broker-dealer to the holding company and the affiliates, and we can look at the off-balance sheets and ascertain the derivatives activity and how derivatives are being used in firms.
Q: What have you found?
A: We're getting a good look at the risk management systems that exist internally in firms. I think it's safe to say that we have, for the most part, a reasonable comfort level with what we see.
Q: How much derivative activity is occurring in unregulated entities like the holding companies and affiliates?
A: Well, for the most part, over-the-counter derivative activity is forced, by current SEC capital rules, into the off-balance sheet affiliates. That's the second program that we have ongoing at the SEC -- we're looking at our net capital rules.
Traditionally, the SEC's net capital rules have taken into account market risk, operational risk, and clearance and settlement risk, but not credit risk. For all intents and purposes, brokerage firms were not in the credit business and, as such, the capital charge for credit risk is 100%. That makes it prohibitive to do many types of derivative activities on the books of broker-dealers.
It's interesting, the SEC traditionally has dealt with market risk, operational risk, and clearance and settlement risk, but not credit risk. The [Federal Reserve] has dealt with credit risk, but not market risk, operational risk, and clearance and settlement risk. These two areas are becoming much more linked because banks are looking much more like brokers and brokers are looking more like banks due to derivatives.
Q: Do the SEC capital requirements put securities dealers at an unfair competitive advantage to banks?
A: There are some aspects of historical rules that make for an un-level playing field on both sides, and that is something that both banking and securities lawyers need to be looking at to even out.
Let me give you an example with regard to how securities dealers may be at a disadvantage. If you are a European counterparty and you have a chance of doing the same swap with a U.S. bank or a U.S. securities dealer, which is often the case, you probably have to factor into your thinking that historically, there has been a too-big-to-fail doctrine for banks in the U.S., but not for securities firms.
Q: You mean the governmental has hailed out banks but not securities firms?
A: You have to suppose that, given your observations of the past 10 years, So if you're a European counterpartyv looking at doing a trade with a U.S. bank or a U.S. broker-dealer that have roughly the same credit rating, do you not require an additional risk premium if you do it with a broker-dealer because the de facto evidence in the U.S. is that there's not a too-big-to-fail doctrine for brokeradealers? That's an un-level playing field.
Some of the capital standards that exist in the banking world versus the broker-dealer world may create an unfair playing field also. That's why I'm very encouraged that there has been a significant increase in the coordination and cooperation among the SEC, the banking agencies, and the [Commodity Futures Trading Commission] with regard to derivatives.
Q: How should the SEC's capital requirements be modified.?
A: We need to rationalize our capital charges for credit risk so that if broker-dealers so choose, they will be able to do this business on-balance sheet, within prudent limits. That's what the capital charges are all about.
But it's premature to discuss that until we get the results from our release asking for comments on possible changes to the net capital rules. The important message today is that we are in the middle of this process. We have received some pretty good input and should be able to take a very hard look at this -- say in the first and second quarter of next year.
But to get back to your earlier question, the SEC program is: risk assessment, our net capital release. accounting, and the fourth point is coordination and cooperation among the federal agencies. The realities are that these instruments cut right across the different agencies.
Q: These have been a lot of press reports on derivative products being sold to unsophisticated investors and at the retail level. Do you think that there should be limits on who can participate in the market?
A: I think the limits exist today. No one has repealed any customer suitability rules. Some firms need to take a hard look at the customer suitability rules. They are out there and they exist today. I certainly, think more guidance can be given in this area, but I don't think we need new customer suitability rules. I don't think some in the marketplace have been as cognizant of the rules as they should be.
Q: Federal Reserve Board governor Susan Phillips has said the industry should consider some sort of clearing house arrangement. What do you think?
A: If it is possible to have a clearance and settlement mechanism for over-the-counter derivatives, we then have to be focused on the fact that one of the natural regulations that exist in the marketplace today would be somewhat compromised. That is, because of the nature of this business, if you do not have a strong credit rating, you get priced right out of this marketplace. You have to have a strong credit rating. The market demands it. A mutualized clearance and settlement system would lessen the need for that natural market prerequisite.
Q: Rep. Jim Leach, R-Iowa, has said derivatives should be regulated by product rather than by institution. He's concerned that insurance companies like American International Group Inc. are not federally regulated. What about that?
A: Clearly, the explosion of derivatives activities is challenging a lot of the tradition and arbitrary boundaries among the regulators. In a perfect world, would we move more toward what the Brady Report called for: one market/one regulator? The answer is yes.
From a practical standpoint, is that likely to happen any time soon? Absolutely not. Therefore. the best practical and near-term answer is for the greatest level of cooperation and co-ordination between these agencies as possible.
Q: What do you think about these calls for any interagency group to be
A: There is a form of cooperation now, and I think that's proceeding just fine. The new chairman of the SEC has regular meetings with his counterparts at the Fed. the Treasury, and the CFTC. I'm not sure what we gain by formalized cooperation.
Q: What's your taken on Congress? Are we going to see legislation?
A: It's clear you're going to see continued keen interest on the part of Congress. There will be even more focus when the General Accounting Office study is released in the next couple of months.
We'll have more hearings. I think what we eventually will see out of Congress will depend on how well the industry embraces efforts such as the G-30 report and continues to move forward in a healthy dialogue with regulators such as the SEC. To the extent Congress is satisfied that significant progress is being made and that there are programs underway at the SEC and other agencies. there won't be as much of a need for action as might now be perceived on the Hill.