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Stronger regulation would help bring financial swaps out of the shadows

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By Mary L. Schapiro
Friday, April 2, 2010

The U.S. economy may be emerging from the financial crisis, but regulatory reform is critical if we are to prevent similar calamities in the future.

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While legislation pending in the Senate would bring a host of vital improvements, important gaps in regulation still need to be closed.

One such gap involves a currently unregulated financial instrument called a "swap." Like all over-the-counter derivatives, a swap's value is derived from an underlying event or asset, such as a commodity, bond or equity security. Swaps are extremely flexible; they can be engineered to achieve almost any financial purpose, such as mimicking the rise and fall of a stock or commodity price, or a change in interest rates or a payment based on an event happening. Businesses, municipalities and hedge funds, among others, that use them can replicate the economics of a purchase or a sale of securities without actually purchasing or selling the securities. This allows users to hedge exposure and manage risk.

But these instruments also carry risks. As we have seen time and again, such swap deals can be rife with conflicts of interest and ripe for abuse so long as they are invisible to regulators and others in the market. They can directly affect regulated markets and concentrate enormous risks in a handful of major financial institutions. And the failure of such institutions can impose costs on taxpayers and the broader economy.

Congress should take three key steps to strengthen the bill:

-- First, create clear lines of regulation. Swaps often are just economic substitutes for the asset or event underlying a contract. It follows, then, that the best chance of detecting and deterring fraud, manipulation or other abuses comes from a cohesive and straightforward regulatory approach -- one in which the same regulator can impose similar requirements on similar products. All securities-based swaps should be regulated as securities; all commodity-based swaps should be subject to commodities laws.

As written, the Senate legislation unnecessarily complicates matters by creating an arbitrary line based on the number of securities in a swap. This would invite users to engineer products to exploit differences in regulation policies. Yes, any regulation is a step in the right direction. But we might be inviting abuse, regulatory gaming and arbitrage if we have one set of rules for trading stocks and options, another for futures, and, say, one for swaps based on nine or fewer securities and yet another for swaps based on 10 or more securities.

-- Second, bring more transparency to this shadow market. Transparency is a core tenet of the securities markets. Both investors and regulators need to know what is being traded, at what price and in what volume. Additionally, the legislation must provide regulators with the information they need to identify trends and combat abuses.

In 2002, while I was a senior executive at the National Association of Securities Dealers, we implemented a trade reporting system -- called TRACE -- for corporate debt securities. Dealers of such debt resisted this effort, just as some swaps dealers are resisting efforts to bring greater transparency to their market. Independent studies indicate that costs are lower for bonds with transparent trade prices and that they drop when the TRACE system starts to publicly disseminate their prices. Such transparency would bring similar competitiveness and efficiency gains into the derivatives market.

Yet the Senate legislation does not empower regulators to require TRACE-like trade reporting. In fact, only a subset of securities-based swap prices would be transparent. This means unspecified areas could still be rife with shadow trading. The Securities and Exchange Commission should be given explicit authority to set minimum transparency regulations on all securities-related swap transactions.

-- Third, maximize the use of clearinghouses and exchanges in transactions involving swaps where possible. A clearing requirement would reduce counter-party risk by substituting the creditworthiness of the clearinghouse for the creditworthiness of the parties to the transaction. Such strong requirements would help to stabilize the market and improve transparency and pricing in the process.

Risk-taking is at the heart of our capital markets. We cannot eliminate risk. We can, however, establish a simple and cohesive set of regulatory tools to ensure that investors and regulators know what risks are being taken and, if necessary, respond accordingly. Moreover, shining a spotlight on swaps would give the market vital information to better price and value them. It would also provide regulators with information necessary to detect and deter abuses.

We are near the finish line for far-reaching financial reform. This is the time to plug any holes. After all, today's gaps can become tomorrow's crisis.

The writer is chairman of the Securities and Exchange Commission.


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