While the Treasury's proposed legislation to regulate over-the-counter derivatives is "an important step forward," the chairman of the Securities and Exchange Commission called for Congress to strengthen the plan to avoid regulatory gaps and eliminate regulatory arbitrage opportunities.

In Sept. 22 testimony before the House Committee on Agriculture, SEC Chairman Mary Schapiro offered her views on the regulation of OTC derivatives and suggested steps to strengthen the Treasury's Department's proposal.

The Treasury plan made public in August would establish a framework for regulating the $450 trillion derivatives market that would divide regulatory responsibility for securities-related OTC derivatives between the SEC and the Commodity Futures Trading Commission, and provide regulatory responsibility for other OTC derivatives to the CFTC.

The proposed legislation is "an important step forward," Schapiro said in prepared testimony. However, she said it should be strengthened in to "further avoid regulatory gaps and eliminate regulatory arbitrage opportunities."

The proposal contains an exclusion from the regulatory scheme for OTC derivatives for products that are "identified banking products."

Although this exclusion may make sense for banks that are regulated in the United States, Schapiro said it could allow foreign banks and their subsidiaries that aren't subject to oversight by any federal banking regulator to offer OTC derivatives to U.S. persons in the guise of "bank products."

She said the exclusion should be revised to make clear that it isn't available to foreign banks or their subsidiaries that aren't subject to federal banking oversight.

In addition, Schapiro called on Congress to minimize regulatory arbitrage and gaming opportunities by regulating swaps like their underlying "references," so that all securities-related OTC derivatives are regulated more like securities and commodities and so that other non-securities-related OTC derivatives are regulated more like futures.

She said the Treasury approach could result in significant regulatory differences between "swaps" products and the currently "regulated" securities and futures products. For example, energy swaps wouldn't be regulated in the same way as energy futures, and securities swaps wouldn't be regulated in the same way as securities.

In evaluating whether to engage in a swap transaction, she noted that market participants are far more likely to focus on the choice between a swap and regulated alternatives than between swaps involving different "underlying" assets.

Those regulatory differences could "perpetuate existing regulatory arbitrage opportunities that encourage the migration of activities from the traditional regulated markets into the differently regulated swaps market," she said. The Treasury proposal would create regulatory arbitrage between narrow-based security index swaps and broad-based security index swaps, she said.

Schapiro called for Congress to extend the federal securities laws to all securities-related OTC derivatives and extend the Commodity Exchange Act to all commodity-related and non-securities-related OTC derivatives to reduce arbitrage opportunities. She said any remaining differences could be addressed through the harmonization process underway between the SEC and CFTC.

She also called for lawmakers to strengthen existing anti-fraud and anti-manipulation authority to provide for examination authority over entities dealing in securities-related swaps; direct access to real-time data on those swaps; and comprehensive anti-fraud and anti-manipulation rulemaking authority for those swaps.

To avoid gaming by financial engineers, Schapiro said Congress should consider clarifying that the definition of "security-based swap" includes not only single-name and narrow-based index Credit Default Swaps, but also broad-based index CDS, and other similar products, when payment is triggered by a single security or issuer or narrow-based index of securities or issuers.

She also called for tougher business conduct standards for dealers and major participants in the OTC derivatives markets to protect smaller and less-sophisticated institutions from abusive practices by swaps intermediaries, and for tougher qualification standards for participation in the OTC derivatives markets.

In addition, Schapiro said she agreed with CFTC chairman Gary Gensler—who also testified before the committee—on the need for legislation to provide for a resolution regime that would place legal restrictions on how counter-party assets held by OTC derivatives dealers and other major market participants would be treated in the event of an insolvency.

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