One assumption people make when downplaying the risk of a far-reaching meltdown in the derivatives market is that regulators have a clear-cut mission; they are level-headed and fully aware of what is going on; and, if disaster should strike, they will iron out whatever jurisdictional, operational, definitional, or other differences they might have for the benefit of the greater good.
A recent dispute over the listing of a new derivatives contract suggests that optimism may be somewhat misguided, however. According to the Financial Times, "US Regulators' Opinions Differ on [the] Same Instrument."
Is it a security? Is it a future? Is it an option?
These questions may seem irrelevant to anyone trading the various types of credit derivatives contracts available in the over-the-counter markets.
But for US markets regulators and two of the largest Chicago derivatives exchanges, they are at the centre of a regulatory row that highlights what, to many, is a fundamental flaw in the way the US capital markets are overseen: too many watchdogs and contradictory approaches to regulation.
For much of the past five months, the Securities and Exchange Commission – which regulates securities – and the Commodity Futures Trading Commission – which oversees commodity and financial futures – have been at loggerheads over how to define two new credit derivative contracts proposed by the exchanges.
In October, the Chicago Mercantile Exchange and the Chicago Board Options Exchange each applied to launch exchange-traded versions of the over-the-counter credit default products that are the fastest-growing segment of the derivatives markets. Small wonder that Chicago is in a hurry to get its products out.
Unfortunately, European derivatives operator Eurex got there first, last month launching the world's first exchange-traded credit derivative.
How did this happen? Part of the answer lies in the fact that the US has one regulator for securities (the SEC) and another for futures (the CFTC). To launch its product, Eurex only needed board approval. Its regulator, in the exchange's home state of Hesse, will only step in if it sees a problem with proposed products.
In October, the CBOE, believing its credit derivative product to be an option, applied to the SEC for approval of its "credit event" products; the CME based its CFTC application on a belief that its products are futures.
The CBOE then took issue with the Merc's definition of its contract and an unseemly spat has played out in eight comment letters posted to the CFTC's website, with both sides arguing their cases in mind-numbing detail.
In essence, the arguments on both sides in this case boil down to a difference in the definition of the underlying instruments on which both exchanges' products are based – that is, whether they are a security or not.
The Merc plans to launch two types of credit event futures, both of which are contracts whose price reflects the probability of "credit events" – such as bankruptcy or failure to pay on a debt instrument – happening to a series of corporate names listed in the products.
The CBOE argues that the products are options, because they are based on securities. It says that failure to pay "necessarily links" the product to specific securities and dictates that the payout on the product on expiry of the contract "can only be determined by reference to those securities".
The SEC sides with the CBOE and is further concerned about the potential for insider trading to which it believes the Merc's product could expose investors – for example, if there was a default prior to the expiry of the contract.
However John Labuszewski, CME's managing director, research and product development, says the events that may trigger a payment on the contract —bankruptcy or a failure to pay — are "events that are not dependent upon the price or value of any security". Thus, they falls outside the SEC's jurisdiction.
The Merc also argues that its contract does not provide for the future delivery or cash settlement of a security "or for the delivery of any measure of value based on a security or an index of securities".
The CFTC has attempted to solve the conundrum in the case of the first of the Merc's two proposed products by approving it on the grounds that it is an option on a commodity. It points out that "failure to pay" is an event that, under a 2000 law passed by congress, was reclassified as a "commodity" – and thus fell under CFTC jurisdiction.
The CFTC is now in discussions with the SEC over how to handle the second CME product.
Some people argue that the solution to such regulatory tangles would be to merge the SEC with the CFTC.
But the risk would be that the more flexible, principles-based regulatory philosophy of the CFTC could be lost as the futures watchdog would be swallowed by its much larger sister agency – which operates on a stricter system of "rules-base" approvals.
The CFTC's approval process, like that of Eurex's home regulator, is to allow exchanges to "self-certify" new products and only step in if it sees a problem.
The saga is unlikely to be the last example of US regulatory dysfunction.
As US exchanges develop ever-more complex products, especially ones where the lines between traditional classifications of "security" and "future" are blurred, they risk being held back from getting their products to market fast enough to compete with foreign rivals – as the Eurex case shows.
Benn Steil, a capital markets and finance expert at the Council on Foreign Relations, says the notion of what the differences are between a security and derivative are at this point are "ridiculous".
"It's only legally meaningful in the US because it determines which one of these institutions [SEC and CFTC] gets jurisdiction – and they are very jealous institutions," he says.
Let's see: jealous, dysfunctional, contradictory, nit-picky, argumentative, and flawed -- these don't sound like the sorts of descriptions you would want to hear about those who are supposedly looking after our financial interests, right?
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