SCHUMER TO FINANCIAL REGULATORS: STOP SHIRKING OVERSIGHT OF COMPLEX DERIVATIVES THAT SUNK BEAR STEARNS
Monday, June 02, 2008; Posted: 07:10 PM
Contact: Brian Fallon (202) 224-7433
SCHUMER TO FINANCIAL REGULATORS: STOP SHIRKING OVERSIGHT OF COMPLEX DERIVATIVES THAT SUNK BEAR STEARNS
In Letter, Senator Questions CFTC, Fed and SEC For Letting Wall Street Firms Police Themselves On Opaque Trades That Pose Systemic Risk
Schumer Asks Whether Exchange Might Be More Effective Than Clearinghouse Announced Voluntarily By Banks Last Week
WASHINGTON, D.C. - U.S. Senator Charles E. Schumer (D-NY) today chided federal financial regulators for taking a "hands-off approach" to the volatile credit derivatives market and questioned whether the voluntary clearinghouse proposed by Wall Street firms last week is sufficient to mitigate systemic risk. Schumer demanded an explanation from the regulators for sitting out discussions leading to the banks' proposed solution for policing its own trades, and asked whether an exchange, rather than a clearinghouse, might be a better fit for a market that represents a $58 liability to the U.S. financial system.
"I am very concerned that the regulatory oversight of the credit derivatives market, like the regulatory oversight of the housing market, has been too lax for too long. There is too much evidence that the unregulated credit derivatives market. is capable of posing a devastating risk to the regulated financial system. We cannot wait for the next crisis before we act to rein in this risk. It is clear that the hands-off approach that U.S. financial regulators have long taken towards over-the-counter (OTC) credit derivatives is no longer appropriate in today's global and interconnected markets," Schumer wrote in a letter to top regulators, including CFTC Chairman Walter Lukken, Federal Reserve Chairman Ben Bernanke and SEC Chairman Christopher Cox.
In his letter, Schumer said it was Bear Stearns' exposure to the largely unregulated credit derivatives market that spurred the Fed to intervene and facilitate the bank's sale to JPMorgan. Schumer said the incident proved the need to bring greater transparency to the trading of these complex instruments, which not even the most sophisticated investors understand in full.
Last Thursday, a consortium of 11 banks announced the establishment of a central platform, run by The Clearing Corporation, for clearing transactions involving certain types of credit derivatives. While hailing the announcement as "an important and necessary step in reducing the systemic risk," Schumer, in his letter, sought the regulators' input on several potential concerns with the clearinghouse arrangement. Among the concerns he cited:
*The success of any clearinghouse may depend on the standardization of derivatives contracts, which has yet to occur.
*The clearinghouse announced last week will deal only with the deep, liquid sectors of the derivatives market, leaving unaffected the less liquid corners of the market such as CDO derivatives.
*The Clearing Corporation proposal will retain the current price and volume opacity associated with the credit derivatives markets. The only parties that will have any visibility into price and volume information would be the clearinghouse itself and the regulators.
A copy of Schumer's letter appears below.
June 2, 2008
Ben S. Bernanke Christopher Cox
Chairman Chairman
Board of Governors of the Federal Reserve Securities & Exchange Commission
20th Street and Constitution Avenue NW 100 F Street, NE Washington, DC 20551 Washington, DC 20549
Walter Lukken Timothy Geithner
Acting Chairman President
Commodities Future Trading Commission Federal Reserve Bank of New York
Three Lafayette Center 33 Liberty St
1155 21st Street NW New York, NY 10045
Washington, DC 20581
Dear Chairman Bernanke, Chairman Cox, and Acting Chairman Lukken,
The near-collapse of Bear Stearns this past March, prevented only by the decisive and unprecedented intervention of the Federal Reserve, exposed a major weakness in our current financial regulatory structure, one which continues to threaten the stability of our financial markets-the lack of risk management for credit derivatives exposure.
I would like to reiterate my support for the actions of the Federal Reserve in the Bear Stearns matter. The consequences of a Bear Stearns default would have been devastating for the U.S. financial system, and ultimately the larger economy. But in the aftermath of the Bear Stearns rescue, I believe it is critically important to ask ourselves why this debacle occurred, and what we as policymakers should be doing to prevent such a situation from recurring.
One important lesson that we have learned from the failure of Bear Stearns is that derivatives trading between sophisticated investors, which is currently largely unregulated, can create enormous systemic risk. According to the experts I have talked to, the rescue of Bear Stearns was necessary not because Bear Stearns was "too big to fail", but rather because it was "too interconnected to fail". Because Bear was such a large player in credit default swap markets, its failure would have been enormously disruptive for its counterparties, and could have caused a severe crisis in the market.
I am very concerned that the regulatory oversight of the credit derivatives market, like the regulatory oversight of the housing market, has been too lax for too long. There is too much evidence that the unregulated credit derivatives market, with its approximately $58 trillion in outstanding credit default swaps, according to the most recent data from the Bank for International Settlements, is capable of posing a devastating risk to the regulated financial system. We cannot wait for the next crisis before we act to rein in this risk. It is clear that the hands-off approach that U.S. financial regulators have long taken towards over-the-counter (OTC) credit derivatives is no longer appropriate in today's global and interconnected markets.
Last week's announcement that a consortium of banks and dealers who represent the vast majority of participants in the credit derivatives market has negotiated an agreement whereby the Clearing Corporation will serve as a central clearing house for OTC credit derivatives is a welcome development, which I applaud. This proposal is an important and necessary step in reducing the systemic risk posed by credit derivatives.
However, it is important we clarify the system of regulatory oversight as well. Given the respective roles played by the Federal Reserve System, the SEC, and the CFTC, I hope that you are already intimately involved in the discussions of how such a clearinghouse would operate, and if you are not, I would urge you to become more involved immediately.
I am also very interested in the idea of facilitating the implementation of a derivatives exchange, and would like to hear your thoughts on how this might work.
In particular, I have the following questions with respect to the regulatory framework for overseeing the derivatives markets:
1.Under the current regulatory structure, the activities of the Clearing Corporation would be regulated by the Commodities Futures Trading Commission (CFTC). However, the events of the past year have made clear that regulatory co-ordination is imperative when it comes to overseeing the risks posed by complex financial instruments and transactions. What discussions has your agency had with the dealers currently involved in the creation of the Clearing Corporation" What discussions have you had with other agencies about the oversight of the Clearing Corporation" What role do you see your agency playing in the oversight of the credit derivatives market going forward?
2.Have you done any analysis to evaluate how the Clearing Corporation as it is currently proposed would impact the current systemic risk posed by credit derivatives" If so, what have you concluded?
3.What regulatory adjustments would you recommend for the Clearing Corporation proposal to work optimally, in a manner that reduces systemic risk to the financial system?
4.The Clearing Corporation proposal will very clearly have a risk management approach designed by the dealer industry, and while the owner dealers will share in the risk held by the Clearing Corporation, it would seem that the dealers would be strongly incentivized to limit their potential risk liability. Do you believe that a dealer-designed clearing house will be an effective device for limiting the risks to financial stability posed by credit derivatives trading" How can regulators ensure that the Clearing Corporation works effectively in aligning dealer interests with those of the financial regulators, and the taxpayers?
5.Some experts have told me that the systemic risk posed by credit derivatives can only be effectively managed if there is sufficient standardization of contracts, since this is a prerequisite for the netting out of various positions. Do you believe that more standardization of contracts is necessary to improve the risk management of currently OTC derivatives" Do you believe that the Clearing Corporation and its owners have the incentives to standardize derivatives contracts?
6.In the discussions that my staff has had with the proponents of the Clearing Corporation proposal, they have learned that the Clearing Corporation will initially begin its foray into the derivatives markets by acting as a central counterparty for only certain types of derivatives, which trade in deeper and more liquid markets. It is unclear when, if ever, the Clearing Corporation will participate in less liquid markets such as CDO derivatives. Given that some of the problems encountered by Bear Stearns may have been caused by its exposure to shallow and illiquid derivatives do you think that the Clearing Corporation proposal will be sufficient to prevent a systemic risk buildup, such as occurred with Bear Stearns?
7.The Clearing Corporation proposal will retain the current price and volume opacity associated with the credit derivatives markets. The only parties that will have any visibility into price and volume information would be the Clearing Corporation itself, as well as its regulator(s). Do you believe that price and volume transparency would help alleviate the systemic risk of the credit derivatives market" What steps are you intending to take to ensure greater transparency in the credit derivatives market?
8.Some have suggested that an exchange would be a preferred mechanism to a private clearinghouse, such as the proposed Clearing Corporation. Do you believe that promoting the implementation of a derivatives exchange would be a worthwhile effort" What would be some of the hurdles to such an exchange" What benefits, if any, would such an exchange provide over the Clearing Corporation proposal" What costs, if any, would such an exchange incur over the Clearing Corporation proposal?
9.If you foresee economic obstacles to widespread participation in a well-designed exchange, do you also see ways increase the incentives of market participants to trade on an exchange?
10. One of the major concerns of either a clearinghouse or an exchange is ensuring that the result is not to push these transactions overseas, away from U.S. regulatory oversight. What recommendations do you have in regards to the structure of either a clearinghouse or an exchange to ensure that this does not take place, and that U.S. businesses remain competitive in these markets?
I appreciate your attention to this critical issue, and look forward to your timely answers.
Sincerely,
Charles E. Schumer
United States Senator |
