Thursday, May 14, 2009

Treasury, SEC, CFTC Call For Reg Reform Of OTC Derivatives

Federal regulators laid out a plan for regulatory reform of the over-the-counter derivatives market. U.S. Treasury Secretary Timothy Geithner announced the plan at a joint press conference yesterday (Treasury Press Release: Regulatory Reform Over-The-Counter (OTC) Derivatives), flanked by Acting CFTC Chairman Michael Dunn and SEC Chairman Mary L. Schapiro.

As background, here are some key points noted in U.S. Moves to Regulate Derivatives Trade by Sarah N. Lynch, Serena Ng, and Damien Paletta in today's WSJ:
  • The regulatory overhauls are in response to growing concerns of outsize risk and leverage among derivatives that trade directly between pairs of firms. Much trading in this market, estimated to total hundreds of trillions of dollars, now happens privately, and contracts are typically negotiated over the phone.... According to the Bank for International Settlements, the theoretical value of outstanding over-the-counter derivatives was about $684 trillion as of June 2008, about $458 trillion of which were contracts tied to interest rates.
  • The Commodity Futures Modernization Act of 2000 allowed most derivatives to escape U.S. federal regulation, but the scale of problems at AIG, which had dabbled heavily in derivatives, and the financial crisis has caused lawmakers and regulators to rethink that position.
  • Federal officials... have said they intend to bring derivatives into the regulatory orbit. Wednesday's proposal, which was laid out in a two-page letter to Congress, was the first time officials added details to their bare-bones ideas.
  • The proposal wouldn't require that customized contracts be traded on an exchange. But traders would be subject to record-keeping and reporting requirements. Derivatives dealers and all other institutions with large counterparty exposures would be subject to regulatory oversight to ensure they don't pose systemic risks to the marketplace, including more conservative capital requirements, business-conduct standards, reporting requirements and margin requirements.... To prevent market manipulation, regulators would also be given authority to set limits on derivative positions if they might have a big impact on markets.

Highlights of Proposal
Below are some highlights from the Obama administration's proposal to rein in regulation of OTC derivatives, based on information contained in Treasury's press release.

  • Amend the Commodity Exchange Act (CEA) and the securities laws to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs). The CCPs will impose: robust margin requirements, risk controls, and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP
  • All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include: conservative capital requirements , business conduct standards , reporting requirements, initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts
  • Amend the CEA and securities laws to authorize the CFTC and the SEC to impose: recordkeeping and reporting requirements (including audit trails), requirements for all trades not cleared by CCPs to be reported to a regulated trade repository movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems, development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information, and encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.
  • Amend the CEA and securities laws to ensure that the CFTC and the SEC have: clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses, authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets, and a complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators.
  • Potentially amend CEA and the securities laws -after CFTC and SEC review and submit recommendations - with respect to participation limits, to potentially tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.

Legislative Action Required
As noted above, amendments to the CEA and securities laws would be required to effect the proposed reforms. See the related letter from Treasury Secretary Geithner to Senate Majority Leader Harry Reid (Geithner letter to Reid) courtesy of

SEC, CFTC Support Changes
At the press conference yesterday, Schapiro and Dunn voiced support for the proposed reform of OTC derivatives. (Dunn statement) (Schapiro statement).

Schapiro stated, "No matter how great our capabilities, no regulator can effectively protect investors from unregulated financial instruments." She added, "Today, current federal statutes significantly restrict the ability of financial regulators to obtain reporting or record-keeping in the OTC derivatives market. Yet these are the very types of tools that any regulator would need to identify suspicious trading patterns or better understand systemic risks. In addition, central clearing for credit default swaps and other OTC derivatives would bring to this market much-needed transparency. Such transparency will enable regulators to better monitor transactions that are effected through the use of a central counterparty. Importantly, central clearing would also mitigate the systemic risks created by OTC derivatives."

CFTC's Dunn said, "Today’s announcement clearly articulates a comprehensive plan that will establish a regulatory framework for currently unregulated markets." He added, "What this means for our economy and particularly the markets we regulate: (1) During the current financial crisis, clearing has been a critical and well-tested tool for reducing risk in our markets. Expanding a centralized OTC clearing system would reduce systemic risk and dramatically increase transparency in these previously unregulated markets. (2) Provides clear authority to regulate these markets and ensure they are free from fraud, manipulation and excessive speculation. (3) The price discovery function of our Country’s futures markets is impacted by OTC derivatives. By regulating these contracts and having the ability to set position limits, we will have the ability and necessary information to ensure market integrity."

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