WASHINGTON - The unregulated subsidiaries that broker-dealers use to conduct their derivatives business should be regulated, SEC Commissioner Richard Roberts indicated in remarks prepared for a derivatives conference in New York City yesterday.
Roberts said what while the Securities and Exchange Commission has not yet addressed this issue, he believes that "a strong argument can be made" that these subsidiaries may be "operating as unregistered broker-dealers" that should be regulated and made subject to SEC's net capital rule, particularly if the SEC decides to treat interest rate swaps as securities.
Roberts' remarks come one day after Howard Kramer, a top SEC staff official, told those attending another derivatives conference in New York that the SEC has left the door open to consider whether interest rate swaps and other derivative products that are not now regulated should be regulated as securities.
Kramer, the SEC's associate director of derivatives and exchange oversight, said on Wednesday that the commission probably would not address the regulatory status of these products until after the agency's capital requirements are revised.
The SEC's net capital rule - designed to ensure that securities firms have enough liquid assets on hand to pay customers and creditors if a default or some other crisis occurs - is being revised to treat derivatives more fairly.
The current rule, which was written without derivatives in mind, is "overly harsh" in its treatment of credit risk for swaps and other such products, Kramer said. The rule treats these products as unsecured receivables and subjects them to a 100% capital charge, he said.
"We want to end up with a capital rule that is both prudent and controls excessive leverage, while at the same time, doesn't impose such a heavy cost to dealers that it forces the activity out of a regulated entity," Kramer told those attending a derivatives regulatory conference sponsored by the Institute for International Research.
Kramer, who stressed that he was giving his own views and not necessarily those of the SEC, told those at the conference, "We've been examining a range of [derivative] products" to see if they should be treated as securities.
Kramer made the comment after he was asked by David Yeres, a partner at Rogers and Wells, about derivative products such as interest rate swaps that are in a "gray area" because they are not currently treated or regulated as securities by the industry or the SEC.
The SEC's review of these products, Kramer stressed, is not aimed at trying to expand the SEC's jurisdiction by bringing into the securities arena derivatives products that should not be treated as securities.
However, if certain derivatives products have the same characteristics as securities and behave like securities, then the SEC may need to address the issue of whether they should be defined and regulated like securities, Kramer said.
Yeres noted that derivatives market participants have been operating under the assumption that such products are not subject to the SEC's suitability rules and other regulations and that any attempt by the SEC to regulate them would be "very disruptive" to the market.
Kramer agreed that there is "a tremendous amount of infrastructure that has been put in place" by derivatives market participants, and that any SEC action changing the regulatory status of a product "is going to have an impact."
"At the same time, for a product that we think are is a security that should be regulated as a security, we're not going to shy away from that merely because somebody's going to call it a contractual arrangement between two parties that keeps it out of the [regulated] broker-dealer," he said.
The SEC, like the Commodity Futures Trading Commission, does not regulate many over-the-counter derivatives products. The CFTC has taken the position that swaps and other such products are exempt from its regulatory authority. But the SEC is still wrestling with whether these products should be treated as securities. Securities firms have been able to avoid SEC regulation by dealing with such products through unregulated affiliates.
Meanwhile, Douglas Harris, senior policy adviser to the comptroller of the currency, said the comptroller is not calling for a prohibition of national banks' use and proprietary trading of exotic and complex derivatives.
Harris was seeking to clarify a speech that Eugene Ludwig, the comptroller, made at the Exchequer Club last week.
The comptroller, he said, has questioned whether restrictions are needed because some medium-and small-size nationally chartered banks are beginning to use complex derivative products that have not been market tested and that have a high price volatility and risks that are not easily understood.
Bank examiners, for example, recently discovered one small bank in Texas with less than $200 million in assets that had purchased such a product for its portfolio. The bank bought a five- to seven-year note that had an initial "teaser" interest rate of 9% that converted, in six months, to a rate based on Spanish and German currencies. The note has since lost about 20% of its value and is not paying the bank anything, Harris said.
"This is just one instance of what we're seeing at some banks," he said. "Some brokers are pushing a lot of this paper on banks who have no business investing in it," he said, referring to exotic derivative products in general.
Harris said that while it is possible the comptroller's office may call for prohibiting banks' use of such products, it may take the more limited step of issuing an advisory letter alerting banks to the special risks of such products and urging them to be cautious.
The comptroller's concerns about proprietary trading stem from the fact that banks are setting up heavily capitalized proprietary-trading desks that are taking large derivatives positions to try to reap substantial profits.
"This is a new development in an old activity," Harris said. "The issue that we're raising is a public policy issue ... and that is to what extent banks should be allowed to use insured deposits to support position taking that is unrelated to dealing, market making, and risk management or reduction."
Harris said the comptroller's office may consider the possibility of risk limits, capital limits, supervisory letters to specific banks, or other reforms. He said, however, that the comptroller's office would seek to take action in concert with other bank regulatory agencies.
On another matter, Harris said he is concerned about a provision in the derivatives bill introduced by House Banking Committee Chairman Henry B. Gonzalez, D-Tex., that would require that a bank chairman be removed and the bank fined for certain derivatives activities that would be deemed unsafe and unsound.
Harris said "that's a pretty harsh result" and that bank regulators should have the flexibility to be able to determine the sanctions for any activities that are deemed inappropriate or violations of banking laws.