SEC's Hu: Rep. Frank's Derivatives Bill Still Leaves Gaps

A top U.S. Securities and Exchange Commission official on Wednesday will tell congressional lawmakers that a draft over-the-counter derivatives bill would weaken the agency's antifraud and market-manipulation authority.

Henry T.C. Hu, who was just recently tapped by SEC Chairman Mary Schapiro to head the agency's new division of risk, strategy and financial innovation, will outline his concerns about House Financial Services Chairman Barney Frank's draft proposal at a hearing Wednesday.

In prepared testimony, Hu said that Frank's bill would "inadvertently weaken the SEC's anti-fraud and anti-manipulation authority" and appears to "enable significant regulatory arbitrage."

"The SEC must have the necessary tools to effectively exercise its authority," Hu said. "This authority should be expanded to include central counterparties and swap repositories, so that the SEC can have quick access to comprehensive data on all securities-related over-the-counter derivatives."

Frank's draft bill, which was circulated Friday, contains many of the same elements of the Obama administration plan, but differs significantly because it does not require all standard derivatives to be traded on regulated platforms and it would allow many more companies to qualify for exemptions from the clearing requirements.

Frank's proposal focuses more on regulating big swap dealers like Goldman Sachs Group Inc. (GS) or Morgan Stanley (MS) and major traders who hold a significant number of positions.

But in likeness to the Obama plan, his proposal would still require major market players to have their standard contracts processed through clearinghouses, which guarantee trade. Customized products not being cleared, meanwhile, would face stiffer capital and margin charges in an effort to entice traders to move onto regulated exchanges. All trades, both standard and customized, would also be reported to a central trade repository to help promote more post-trade price transparency and the SEC and Commodity Futures Trading Commission would both oversee the marketplace.

Part of the problem with the bill, Hu said, is how it divides jurisdiction over swaps between the SEC and CFTC. Like the administration's plan, it would give the SEC authority over swaps referencing single securities and narrow-based indexes while giving the CFTC power over swaps referencing broad-based security indexes.

In addition, he said, the draft would regulate swaps differently from futures or stocks and also fails to define security-based swaps as securities under the Securities Exchange Act. Without including security-based swaps in that key law, Hu said, it will be harder to apply certain anti-fraud provisions including insider-trading.

Separately, Hu also questioned Frank's decision to deviate from the Obama plan and provide a broader group of end-users with the ability to get exemptions from the clearing requirements.

"A narrower, objective and verifiable standard would be more consistent with the purposes of the legislation," he said.

Still, he noted, the bill represents a "significant step toward addressing current problems" in the over-the-counter market.

-By Sarah N. Lynch, Dow Jones Newswires; 202-862-6634; [e-mail].