Greenberg Traurig Alert

Federal Regulators and Congress Focus on Derivatives in 1995

January 11, 1995

Even before the financial collapse of Orange County, California, which was caused in large part by speculation in derivative investments, federal regulators had focused their attention on whether existing regulations were providing sufficient disclosure for purchasers of high-risk derivatives. In the closing weeks of 1994 Bankers Trust, one of the leading derivatives dealers, agreed to a series of consent orders with the Federal Reserve Board (FRB), Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) to pay $10 million in fines and to revise its sales techniques after being accused of fraudulently misleading purchasers of certain exotic derivative instruments. This week Chairman of the House Banking Committee, Rep. James Leach of North Carolina, introduced legislation to create a federal Derivatives Commission; at the same time the Senate Banking Committee held hearings on whether additional legislation was necessary.

While no one can predict what Congress will do in this highly complex area, recent actions by federal regulators provide some guidance for the future regulation of the more complex derivatives.

Growth of Derivatives Market

Historically, the largest number of financial instruments that fall under the heading of derivatives have been futures and options on futures for financial instruments that are traded on the various commodities exchanges regulated by the CFTC. What these instruments share in common is that their value is derived from the underlying value of the instrument involved, such as a Treasury bond or foreign currency. However, in addition to derivatives which are traded on exchanges, there are now a large number of derivatives that are traded over the counter and off exchanges.

It is these derivatives, commonly know as "OTC derivatives", that are the focus of recent regulatory attention, since they have not traditionally been viewed as falling squarely into any particular federal regulatory agency's jurisdiction. The most widely used OTC derivative is a swap: a contractual arrangement between counterparties to make periodic payments to each other based on a price index (e.g., interest rate or foreign exchange rate) for a specified period of time. While swaps have been extremely useful in hedging financial risk, and their growth has been a major factor in stabilizing world markets, they also have some risks that are not found in the exchange-traded derivatives.

Moreover, in the last few years the swaps market has grown from a few global financial companies to a market that now reaches all levels of financial institutions, corporations, governmental entities, money market and pension funds. The notional value of the swaps market is now estimated to be near U.S. $12 trillion. The OTC derivatives now being traded range from "plain vanilla" swaps (described above) to "inverse floaters" and "structured notes", which in certain cases have such compli-cated formulas for deriving value that only the most sophisticated dealers can understand them. In fact, with the use of modern computer software, the possible variations for OTC derivatives seem endless.

Anticipated Regulatory Actions

Although federal regulators have consistently opposed broad regulatory change, and have also insisted that their actions regarding Bankers Trust were in response to a particular incident allegedly involving fraud, some conclusions can be drawn from the Bankers Trust orders.

INCREASED COORDINATION BETWEEN AGENCIES:
Bankers Trust was subject to the jurisdiction of the FRB, since Bankers Trust is a bank holding company; the SEC, since the Bankers Trust unit responsible for the sale was a registered broker/dealer; and the CFTC, since it found Bankers Trust had acted as a "commodity trading advisor". The analysis conducted by each agency will be carefully examined over the next year by federal and state agencies, the Administration, Congress, foreign bank regulators and the international financial markets. However, of indisputable significance is that the agencies coordinated their efforts to ensure the final orders imposed on Bankers Trust would provide corrective action without inadvertently and adversely affecting the stability of the overall OTC derivatives market.

ENHANCED SUPERVISION OF FINANCIAL INSTITUTIONS:
The Comptroller, FRB, FDIC, OCC, SEC and CFTC can be expected to continue expanding their supervision of financial institutions to ensure senior management oversight of dealings in derivatives. Emphasis will be put on adequate capital, accounting standards and risk management controls. Similar programs are likely to be considered by state agencies responsible for supervising other financial institutions (such as state-chartered banks and insurance companies), but whether the states will extend their supervision over municipal finances (such as county treasurers) as well is a far more complex question. Another issue will be the level of senior management oversight. The Bankers Trust order requires its Board of Directors to review proposed plans and procedures for the sale of leveraged derivatives before such plans and procedures are submitted to the FRB for its approval.

EMPHASIS ON AFFIRMATIVE DISCLOSURE OF RISK:
Although the Bankers Trust orders were drafted in response to allegedly fraudulent sales techniques, key provisions of the orders regarding disclosures could become standard for the sale of complex derivatives. The affirmative disclosures required of Bankers Trust are intended to ensure that future purchasers of leveraged derivatives have "the capability to understand the nature and material terms, conditions and risks" of these particular instruments. Regulators describe this as an "appropriateness" test, rather than the suitability standard normally used for the sale of securities. In order to meet these obligations, Bankers Trust will have to provide customers, at the outset, with detailed analyses which describe a series of possible risk scenarios; provide updates on the risk scenarios as requested by the customer; and provide periodic quotes as necessary (even on a daily basis) for the customer to analyze the risks. Whether an appropriateness test will be required for other complex derivatives or for other financial institutions generally will be the subject of intense debate by the regulatory agencies and Congress in 1995.