Regulatory restructuring proposal may greatly affect participants in currently unregulated over-the-counter (OTC) market.

The Acting Chairman of the Commodity Futures Trading Commission (CFTC) outlined a proposal for a major overhaul of the regulatory framework overlaying the financial system. Speaking to the Futures Industry Association at its 2008 Futures and Options Expo in Chicago, Acting Chairman Walter Lukken set forth a plan to replace the "current outdated regulatory framework" with the flexibility of an objectives-based system covering the broader financial markets. Acting Chairman Lukken feels that this is necessary to keep pace with the rapid innovation of the financial markets. If the changes presented were implemented, they would have significant implications for the financial markets, particularly for participants in currently unregulated over-the-counter (OTC) markets.

Under this proposal, three primary authorities would take over the functions of the CFTC, the Securities and Exchange Commission (SEC) and various banking regulators.

A new Systemic Risk Regulator would police the entire system, watching for risks with the potential to cascade through the system, and taking preventative action. Acting Chairman Lukken saw no analogous regulator in the current system, but presented it as essential given the interconnectedness of the financial markets and the speed with which a crisis can spread.

A new Market Integrity Regulator would "oversee the safety and soundness of key financial institutions, including exchanges, investment firms and commercial banks whose failure may jeopardize the integrity of the markets."

Finally, a new Investor Protection Regulator would oversee investor protection and business conduct across all firms in the marketplace.

In addition to adding a new structure to the regulation of financial markets, Acting Chairman Lukken indicated that it was critical that the emphasis be changed from a rules-based approach to an objectives-based approach. He advocated this as a way to improve market transparency, apparently in part by regulating some additional OTC markets. This approach, based on "objective rather than function will ensure that all products and institutions are properly overseen based on identified public risks rather than futile and difficult determinations of whether an instrument is a security, a future or a swap contract." Acting Chairman Lukken proposed the recent Farm Bill as a model for new reporting requirements of exchange and OTC market data. The Farm Bill added reporting requirements for significant price discovery contracts in OTC energy swap markets. Acting Chairman Lukken suggested similar reporting requirements for other contracts that serve a significant price discovery function.

Acting Chairman Lukken argued that the CFTC already uses an approach that emphasizes objectives rather than rules, in what he deems a successful bid to keep pace with the fast moving global markets. He recommended market wide application of this emphasis in part because it "helps prevent institutions from making end runs around static rules when such actions violate broader public policy." He appears to believe that any loss of predictability on the part of market participants would be outweighed by increased flexibility for regulators to address novel and quickly developing situations.

Acting Chairman Lukken argued that the complicated and jurisdiction-spanning nature of the necessary financial reform would be best addressed by a bipartisan Congressional committee. In the short term, he warned against a simple merger of the CFTC and the SEC without broader reform but advocated the establishment of a unified regulatory board, consisting of the heads of the Federal Reserve, the SEC and the CFTC armed with joint rulemaking and exemptive authority to "eliminate regulatory gaps and duplications that currently exist in the system."

As to actions the current regulatory bodies should take, Acting Chairman Lukken urged others to follow the CFTC's lead in aggressively supporting efforts by market participants to create a clearinghouse for credit default swaps. He saw great benefits in the transparency, standardization and risk management that clearinghouses bring. Noting that no U.S. futures clearinghouse had ever defaulted on a guarantee, he vowed to work expeditiously to approve credit default swap clearinghouses that demonstrated compliance with high regulatory standards.

Finally, noting that the financial crisis spread rapidly around the globe, Acting Chairman Lukken urged greater cooperation internationally, including a discussion of standardization of market data to speed sharing of information among regulators, and to consider reducing the differences in the treatment of consumer assets around the world stemming from different bankruptcy laws.

To view a transcript of Acting Chairman Lukken's speech, click here.

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