Dealers in over-the-counter derivatives need to spell out the terms of their relationships with institutional customers to help avoid conflicts over the recommendations they make, said SEC commissioner Steven Wallman.
If the relationships between derivatives dealers and their customers in over-the-counter derivatives transactions were better clarified, suitability requirement questions would be less of an issue, Wallman - who is one of two sitting members on the five-member Securities and Exchange Commission - said earlier this month in an interview with The Bond Buyer.
"I think the counter to the argument that says there should be a general suitability requirement across the board is there should be a general clarification in the relationship across the board," Wallman said, predicting that many problems with dealer recommendations would likely "evaporate."
He warned that imposing a broad requirement on firms - regardless of their role in an over-the-counter derivatives transaction or the sophistication of their customer - that holds them liable for recommending suitable investments to their institutional customers would have a "harmful effect" on the industry and the ability of firms to manage risk.
"I believe strongly that clarifying the relationship is the better alternative, but also I believe strongly that it is the dealers that have to do it," he said.
Wallman also cautioned that it would be a mistake for regulators to impose tough disclosure rules on the over-the-counter derivatives industry
"That, I think, would be devastating," he said, speaking of the alternative of requiring dealers to provide a detailed prospectus every time they enter into an over-the-counter derivative transaction.
The dealer community, Wallman said, has a better argument: it should not be responsible for the decisions sophisticated investors make as long as the terms of a relationship are made clear.
"I think that if dealers don't clarify the relationship (in over-the- counter derivative transactions), the default that people will suggest is suitability," he said.
State and local government representatives including the Government Finance Officers Association have said repeatedly that dealers need to be held responsible for making only suitable recommendations when selling over-the-counter derivatives.
At the same time, the derivatives dealer community has argued that they cannot be the guarantors of risk for institutional customers, emphasizing that these transactions are conducted at arm's length.
Wallman charged that investors ought to understand the investments they are making, ensure that they have contracted for the dealer to act as their fiduciary, or hire independent advisers to assist them if they don't understand a transaction.
He said that the more exotic and custom-tailored over-the-counter products are not the type of financial instruments that customers must absolutely buy to effectively manage risk.
"If they do think they have to have them, then they ought to understand why and be able to come to that conclusion on an informed basis," he said.
Nonetheless, Wallman said he believes industry participants, including members of the end-user community and regulators, are all moving in the same direction.
"I think that we are all moving towards the notion that there should be a clarification of the relationship, and that takes care of a lot of issues," he said. "There are very few people that have argued that there shouldn't be a clarification in the relationship. It's hard to sit and say that ambiguity is good."
However, he noted that a major obstacle exists because over-the-counter derivatives dealers and investors are currently at odds over who should take the first steps to define the terms of a relationship.
"The remaining issue is really the question of who's got the obligation to first note that this is a relationship with ambiguities and who has the obligation to clarify it," Wallman said.
Industry Guidelines
For example, a group led by the Federal Reserve Bank of New York that included representatives from the Public Securities Association, the International Swaps and Derivatives Association, and the Securities Industry Association drafted controversial guidelines that treat dealers and end-users equally.
"The only question is who's got the obligation to clarify the relationship," Wallman said.
Wallman expressed concern that these industry-drafted guidelines, called the "Principles and Practices for Wholesale Financial Market Transactions," don't effectively establish that dealers must make sure the customer understands the terms of the relationship.
"I've not heard an argument that is at all persuasive that would suggest that the obligation should be imposed on the end-users," Wallman said.
Not putting the burden on dealers would be inconsistent with standards employed in other professions, he said.
"It's just hard to understand the logic or rationale that says you would impose the obligation on the other side. It would sort of be like having an obligation imposed on all potential clients of lawyers to figure out whether or not there is some legal ethics issue that the lawyer has to struggle with," Wallman said.
"Nobody would suggest that is reasonable."
As in every other profession, he said it is incumbent on the professional to explain to his customers the issues that exist, as opposed to expecting the client to figure them out or ask the appropriate questions.
Furthermore, Wallman said it's easier for the SEC and other regulators to get their message to the dealer community rather than try to identify potential derivatives customers.
"We can get basically all the dealers in one room to talk to them. We can't do that with the end-users," he said.
"Just in terms of contracting efficiencies, you've got a much smaller group of people on the derivatives dealer side than the end-users side," he said, adding that the dealer community also has a better understanding of the derivatives markets.
"In terms of the sophistication and understanding of what the issues are, understanding the nuances, and being able to clarify (them) - clearly the dealers are in a far superior position to clarify relationships than the end users," he said.
Differential Treatment
Meanwhile, Wallman said if relationships could be clarified, one might reasonably expect differential treatment of over-the-counter derivative users to develop.
"The notion of two-tier treatment of end users in other contexts, such as the use of 'accredited investor' or 'qualified institutional buyer' is one that has been implicit in the securities laws for time immemorial," Wallman said. "You are better off having more tailored protections for those that need it in different circumstances."
He said the system is more efficient if it is more tailored but that these added protections should not be imposed on bigger and more sophisticated institutions that don't need them.
"The question then is, 'How do you draw the line?' " Wallman said. "Where one draws the line is always going to be somewhat arbitrary because you can always come up with an example of somebody who should have been on the other side."
Wallman cautioned that size alone is not likely to be the best measurement for determining a customer's sophistication.
"You might be better combining size with something else or eliminating certain entities," he said. "You could say, for example, a school board with $10 million of assets may still not be the most sophisticated instrumentality in the country for dealing in derivatives.
"On the other hand, a registered investment adviser operating a sophisticated hedge fund that is starting with $10 million under management might be fine," he said.
The National Association of Securities Dealers has proposed rule changes requiring dealers to take a number of steps to determine whether or not an institutional customer is relying on their recommendations.
Size of a customer, meaning the dollar amount of assets under management, is one of several factors dealers would be directed to consider under the NASD proposal.
Although the proposal has yet to be acted on by the SEC, Wallman indicated his preliminary view that the rules may be a step in the right direction.
Wallman said the message is out there to dealers and investors alike that they need to use common sense. He indicated that dealers from both a marketing and risk perspective will need to ensure that safeguards are in place to help curb financial disasters.
"It is going to be hard to see how they will over time continue to have good relations with clients if things go wrong," he said. "I think it is incumbent on the industry to protect its own franchise here and to ensure that it does not have those accidents and mistakes occurring."
However, Wallman cautioned that investors getting into these markets need to understand that they might lose money.
"Making more informed decisions doesn't mean that people won't lose money trading in derivatives. Somebody is going to lose money and somebody is going to make money. But they should understand the risks," he said.
