WASHINGTON -- The General Accounting Office concluded in a recent report that the over-the-counter derivatives activities of major broker-dealers are virtually unregulated because they are conducted through affiliates that are unregulated.
Derivatives market participants, however, disagreed with the GAO in congressional hearings on the report. They said that securities firm affiliates are regulated.
Who is right?
Based on interviews with Securities and Exchange Commission and industry officials, it appears that while the affiliates must meet some SEC reporting requirements, they are not subject to most of the regulatory requirements imposed on broker-dealers.
The SEC regulates the activities of broker-dealers, the firms that buy and sell securities for customers and for their own accounts.
All financial products that are defined as securities, such as stocks and bonds, must be bought, sold, and traded through regulated broker-dealers.
Broker-dealers must register with the SEC. They are subject to reporting, disclosure, and capital requirements. They must submit to periodic examinations. They must also comply with the requirements of the exchanges and of self-regulatory organizations such as the National Association of Securities Dealers.
Generally, however, the SEC's regulatory purview does not extend to the holding companies or affiliates of broker-dealers whose activities involve products that are not defined as securities, including interest rate swaps and certain other over-the-counter derivative products.
Under the Market Reform Act of 1990, the SEC has limited authority to collect derivatives information from broker-dealer holding companies and affiliates, with the idea that such information is necessary to determine whether these entities pose risks to their broker-dealers.
Under the risk assessment rules that the SEC wrote to implement the act, broker-dealer affiliates and holding companies are required to report quarterly on the notional and replacement amounts of futures, forwards, options, and swaps positions. They must also describe their derivatives risk management procedures and systems.
In addition, individual counter-party credit exposures must be reported if they exceed $100 million, 10% of the broker-dealer's net capital, or 10% of the affiliate's net worth, whichever is greater.
The SEC does not, however, receive information that shows the gains and losses from derivatives separated out from other trading activities, according to the GAO.
The affiliates and holding companies are not subject to most of the regulatory requirements that the SEC applies to broker-dealers.
They are not subject to capital requirements, which call for the broker-dealer to have enough liquid assets on hand to satisfy the claims of customers and creditors.
They are not subject to requirements detailing the information that broker-dealers and other registered companies must disclose about their derivatives activities in quarterly and annual reports and other filings with the SEC.
Derivatives market participants say the affiliates are subject to reporting requirements under the Market Reform Act of 1990. In addition, they say, the affiliates must maintain certain levels of capital and meet other standards to obtain and retain triple-A credit ratings from the rating agencies.
The major dealers, working through the Securities Industry Association, and the SEC have agreed to come up with capital and other standards that could be voluntarily complied with.
But the GAO says that whatever self-imposed or industry-imposed standards the affiliates try to meet, they still are not subject to any oversight or examination from the SEC. The SEC has no way to verify that the information it is getting from the affiliates is correct or that the affiliates have adequate derivatives risk management systems in place, the GAO says.
GAO officials have contended in hearings that the major broker-dealers with derivatives affiliates and holding companies -- a handful of securities firms -- should be regulated in the same manner as banks that deal in or use derivatives. They claim that the United States is the only major country in the world in which there are derivatives dealers that are virtually unregulated by the federal government.
