Sept. 2 (Bloomberg) -- Speed and pricing in the $592 trillion over-the-counter derivatives market is being hampered by dueling U.S. regulations that should be consolidated, Chicago Board Options Exchange Chairman William Brodsky said.

“These disparities have created competitive inequalities between the securities and futures markets and have resulted in unintended but nonetheless negative consequences,” including price distortion, unnecessary trading delays and impediments to competition, Brodsky told a joint meeting of the Securities and Exchange Commission and the Commodity Futures Trading Commission in Washington today.

Brodsky advocates a flexible, “principles-based” system, like that used by the CFTC, over the rules-based regime of the SEC. Brodsky is among 30 industry executives, traders, consumer groups and former enforcement officials called to testify at hearings today and tomorrow that will examine ways to coordinate oversight of the little-regulated derivatives industry.

President Barack Obama is pushing Congress for a sweeping rewrite of industry regulations this year after the global financial crisis shut down credit markets, pushed companies into bankruptcy and worsened the recession. Obama asked CFTC Chairman Gary Gensler and SEC Chairman Mary Schapiro to determine how best to share their overlapping regulatory responsibilities.

“There are areas where the CFTC and SEC regulate similar products, practices or markets, but do so differently,” Gensler said today. “There are times when these differences are appropriate, but at other times, they could stifle competition, increase costs or limit investor protection.”

All Options Considered

Gensler said “all options must be on the table” for filling in the gaps in the financial regulatory system.

Schapiro said at today’s meeting that some of the disparities in regulations are necessary for the individual agencies to achieve their policy objectives. She did say she would work with Gensler to align some efforts in the regulation of markets for securities and futures.

“Many benefits could be achieved through greater coordination and harmonization between the SEC and the CFTC for regulation and oversight of similar types of financial instruments,” Schapiro said. “Some of these benefits include increasing transparency, reducing regulatory arbitrage, promoting product innovation, and rebuilding confidence in our markets.”

Turf War

Former SEC Chairman Arthur Levitt said in an interview that the outcome of these meetings will largely depend on whether Congress is willing to take action.

“It’s a turf war being fought by people and agencies largely unable to resolve the central issues,” Levitt, who is now a senior adviser to the Carlyle Group and a board member of Bloomberg LP, told Bloomberg Radio today. “Congress has got to address these fundamental differences before the agencies themselves can get down and dirty.”

Lawrence Leibowitz, head of U.S. markets for NYSE Euronext, and Options Clearing Corp. CEO Wayne Luthringshausen agreed with Brodsky that it might be better to follow the CFTC’s approach.

“The regulatory philosophies pursuant to which the SEC and CFTC approach their supervisory responsibilities differ significantly, with tangible consequences for the exchanges that fall under their respective jurisdictions,” Leibowitz said in his prepared testimony.

SEC Rules

The SEC’s requirements that regulated exchanges file amendments to the agency for rule changes, trading platforms and products limit innovation, he said.

“The rules-based approach has led to significant delays in the implementation of some rules at exchanges, as well as deferral or outright loss of new product innovation of exchange- traded products, many of which ultimately end up in the OTC market,” Leibowitz said.

Luthringshausen, whose Chicago-based company says it’s the largest equity derivatives clearing organization, is pushing for a consolidation of derivatives oversight functions.

“We do not believe that the current regulatory structure for derivatives is the optimal one,” Luthringshausen said. Efforts by the agencies to coordinate statutes and regulations for exchange-traded and over-the-counter derivatives “is an important and necessary first step,” he said.

Regulatory Mold

Under the Obama proposal being considered by Congress, primary responsibility for derivatives tied to equities, including credit-default swaps, would go to the SEC. Other derivatives, including those related to interest rates and commodities, would be regulated by the CFTC, the two agencies told Congress June 22.

Craig Donohue, CEO of CME Group Inc., the world’s largest futures market, warned against forcing dissimilar markets into the same regulatory mold.

“Harmonization does not include a merger of the existing regulatory structures into a single set of one-size-fits-all rules administered by separate agencies,” he said in prepared remarks. “This would lead to duplicative regulation.”

The SEC and CFTC differ in how they regulate margin requirements, defaults, new product approvals and bankruptcy, among other issues.

Brodsky said the divided jurisdiction, if left intact, could create legal uncertainty and unnecessary delays for new products. He also said differences in how the agencies set margin requirements -- with the CFTC leaving it up to futures markets and the SEC approving equity option margin levels -- tilt competition.

Level Playing Field

“Lower margin levels provide futures with a cost advantage over options that is not justified by differences in the risks between the two products,” Brodsky said. Stock index futures contracts typically carry a margin requirement of about 5 percent or less, while sellers of stock index options generally have to post as much as 20 percent, he said.

“The result is that equivalent products do not compete on a level playing field solely because they are subject to separate margin oversight,” Brodsky said.

Obama called on Schapiro and Gensler in June to make recommendations to Congress by Sept. 30 for eliminating differences in oversight. Gensler has said the deadline will be difficult to meet and the agencies may issue an interim report.

Columbia University securities law professor John Coffee said that the CFTC needs more of the powers the SEC has to act on cases of insider trading and market manipulation.

The CFTC “needs legislation prohibiting insider trading on commodities and transactions within its jurisdiction” and should be able to impose financial penalties in cases of violations. The SEC “is armed with a greater enforcement club” and can impose penalties without going to court, Coffee said.

“The bottom line here is that it would make sense to harmonize these penalty levels so that both agencies had equivalent powers,” he said.

To contact the reporters on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Joshua Gallu in Washington at jgallu@bloomberg.net.

Last Updated: September 2, 2009 12:36 EDT