WASHINGTON - The Securities and Exchange Commission may have taken a step toward regulating municipal and other kinds of derivatives by issuing a rule requiring securities firms to report their holdings in them, some market participants said this week.
The temporary rule, which takes effect Sept. 30 and expires at the end of 1994 when the SEC is to decide whether to make it permanent, is designed to help the agency estimate the risks involved in the burgeoning derivatives market. But it also would increase administrative costs for broker-dealers, according to some market participants.
Derivatives - interest rate swaps, forwards, and options - have avoided the scrutiny of the SEC and other regulations because they are generally traded through holding companies and affiliates of broker-dealers, rather than by the broker-dealers themselves.
Broker-dealers in securities are currently required to register with the agency and report regularly on the volume and type of securities they hold, but their holding companies and affiliates generally are not.
The little-noticed rule approved by the SEC last week does not call for extensive regulations of derivatives. But it does, for the first time, require holding companies, affiliates, and subsidiaries of brokerage firms to report their holdings in quarterly financial reports they file with the SEC. In some cases, the information will have to be reported monthly.
One market participant said the rules "might be a first step toward regulation of activities of broker-dealer affiliates or capital requirements for specific types of derivatives. There's nothing in the rules that suggests this, but clearly the SEC is trying to collect information to understand this for reason."
Mandated by Congress in the Market Reform Act of 1990, the rule is designed to send an early warning signal to the SEC about firms in financial difficulty. The law, which permits the SEC to obtain immediate financial information from broker-dealer holding company systems, was passed in response to the October 1987 stock crash, the November 1989 minimarket crash, and the collapse of market crash, and the collapse of Drexel Burnham Lambert Inc.
Dealers in swaps and other derivatives have argued that additional regulations is not needed because the deals are done by sophisticated parties. "But municipal issuers strain that definition," said one key market observer.
While the situation may differ from firm to firm, the source said municipal swaps, forwards, and options are typically done out of the parent or separate subsidiary, not the broker-dealer. "The broker-dealer may arrange [the deal], but it's booked against a different entity," the source said.
"Firms often do not like to do such deals out of the broker-dealer-... because they don't get favorable treatment under the SEC's net capital rule," he said, referring to the commission standard that requires broker dealers to maintain a maximum ratio of indebtedness to liquid capital.
"If a firm does back-to-back swaps - swapping a fixed interest rate from a municipality for a floating rate and then turns around and swaps the floating for a fixed to someone else - that's considered to be two unsecured loans' under net capital rules, the source said. "The firm has to take a hit on net capital."
Banks and insurance companies are exempt from the new rules and broker-dealers will be exempt if they or their affiliates have less than $5 million in capital or have less than $20 million in capital and maintain less than $250,000 in customer accounts. Other organizations can apply for an exemption to the rules under certain circumstances, such as if they already report this information to other regulatory agencies.
The rules cover any holding company, subsidiary, or other affiliate of a broker-dealer whose "business activities are reasonably likely to have a material impact" on the broker-dealer's financial and operational condition. Factors in making this determination include the degree to which the broker-dealer and its customers rely on such organizations for services or support; the level of risk present in the activities of the broker-dealer and its affiliates; and the extent to which the affiliates have the ability to cause a withdrawal of capital from the broker-dealer.
The information that broker-dealers and affiliates must maintain and submit to the SEC in periodic reports includes organization charts showing the broker-dealer and all of its entities, and a description of any ongoing legal proceedings that could affect the operations or finances of the broker-dealer or affiliates.
Firms also must supply consolidated financial reports that include information on the affiliates as well as the broker-dealer. Currently, only public companies are required to submit financial reports, and while a parent company might be public, its affiliates might not. They also must report additional information such as aggregate securities and commodities positions, bridge loans, and certain unsecured extensions of credit or lease financings.
For interest rate swaps, the rules require information on the "notional," or principal amount of the swap contract.
For swaps and forwards, information must be supplied on the cost of replacing a contract and each transaction in which the credit risk risk exceeds a "materiality threshold." The SEC defines the threshold as the greater of $100 million or either 10% of the affiliate's net worth or the broker-dealer's tentative net capital based on its most recent annual report to the commission.
The SEC said information supplied by broker-dealers under the rule would be kept confidential and would not be released under the Freedom of Information Act.
Many broker-dealers and their lawyers said yesterday they are not familiar with the rule. Others refused to comment. Mark Holloway, a vice president of the financial division at Goldman, Sachs & Co., said, "I don't know what, if any, impact these would have." He said, "People have known that they were going to be subject to these for a very long time."
Beside the SEC, Congress is also growimg increasingly concerned about the amorphous derivatives market. A House subcommittee last month asked the General Accounting Office to determine how well broker-dealers and other financial associated with derivatives, with an eye toward holding hearings on the issue next year. The report is not expected until the summer of 1993.