November 18, 2009

The regulations proposed by the Administration regarding reform of financial markets, Over-the-Counter Derivatives Markets Act of 2009, are insufficient. They do not go far enough in reforming derivatives markets and they do not strengthen at all the competitiveness of U.S. financial markets versus other well-respected markets. The following six recommendations will achieve these objectives.

What has occurred over the last year is profoundly unfair to U.S. taxpayers, who have been called upon to rescue poorly run Wall Street firms. We currently have a system where heads Wall Street wins, and tails the U.S. taxpayer loses. The first three recommendations therefore are designed to minimize the current moral hazard that exists in the U.S. financial system, where some Wall Street firms have been considered too big and interconnected to fail.

1. Regulatory oversight of all derivatives must be comprehensive and consistent, with no exceptions or diminished oversight for certain classes of derivatives or types of firms. The Commodities Exchange Act (CEA) should apply consistently to all derivatives (including forwards), regardless of instrument type. Loopholes for excluded, exempt and agricultural commodities should be removed. Any financial instrument sold directly to the public should be regulated. A derivative should be defined as any financial instrument that is not a security and that does not clear and settle within one day of trade date. The current regulatory scheme, where certain derivatives market segments are not regulated or very lightly regulated, has spectacularly failed.

2. All OTC (Over the Counter) derivatives, regardless of instrument type, should be required to participate in a trade reporting system, preferably TRACE. FINRA's TRACE system has been used successfully since 2002 in the U.S. OTC fixed income market. Trade reporting will increase market transparency, allowing more effective regulatory oversight and also stimulating electronic automation and competition.

3. All OTC derivatives, not just a subset, should clear with protection against counterparty risk. This result could be achieved by requiring that all derivatives clear in a centralized clearinghouse, or centralized clearinghouses augmented by a new mechanism, a "DIPC" (similar to the SIPC, or Securities Investor Protection Corporation). A DIPC would collect fees from counterparties and offer protection against counterparty risk for trades that are not yet sufficiently standardized to clear in a regulated clearinghouse. Bilateral clearing without protection against counterparty risk should no longer be allowed under any circumstances. Protection against counterparty risk greatly reduces the interconnectedness of firms holding derivatives contracts.