Financial Crisis Inquiry Commission Hearings Reveal Broad Support for Legislation to Regulate OTC Derivatives

Recent hearings of the Financial Crisis Inquiry Commission revealed deep and broad support among regulators and financial industry leaders for federal legislation regulating OTC derivatives. The Commission was created by Section 5 of the Fraud Enforcement and Recovery Act of 2009 to examine the causes of the current financial and economic crisis in the United States and report its conclusions to the President and Congress by December 15, 2009. Late last year, the House passed legislation placing the OTC derivatives market under joint SEC-CFTC regulation. Similar legislation is currently under consideration in the Senate.

Commission Member, and FDIC Chair, Shelia Bair said Congress should require that all standardized OTC derivatives clear through appropriately designed and central counterparty systems (CCPs) and, where possible, trade on regulated exchanges. To ensure necessary risk management, the CCPs and exchanges must be subject to comprehensive settlement systems supervision and oversight by federal regulators.

Recognizing that not all OTC derivatives are standardized, Member Bair said that, in those limited circumstances where customized OTC derivatives are necessary, the contracts should be reported to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices. She emphasized that this is an essential reform to reduce the opacity in the OTC market that contributed to market uncertainty and greatly increased the difficulties of crisis management.

Currently, trade repository information is not yet complete or available to all regulators who need it. For example, the FDIC as deposit insurer and receiver, does not currently have access to end-user data from the CDS trade repository. This gap must be closed, she insisted. In addition, improved transparency is vital for a more efficient market and for more effective regulation.

In her view, the clearance of standardized trades through CCPs and the reporting of information about customized derivatives will greatly improve transparency. To achieve greater transparency, she continued, it is essential that CCPs and trade repositories be required to make aggregate data on trading volumes and positions available to the public and to make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity.

Commission Member Brooksley Born urged Congress to act quickly to regulate the OTC derivatives markets. The former CFTC Chair said that exempting OTC derivatives from federal regulation in the Commodity Futures Modernization Act of 2000 was a ``profound shortcoming’’ of government regulation. Through rampant speculation and excessive leverage, she noted, opaque OTC derivatives spread and multiplied risk and contributed to the financial crisis

Commission Member, and Goldman Sachs CEO, Lloyd Blankfein supports a broad move to central clearinghouses and exchange trading of standardized derivatives. He advocates a central clearing house with strong operational and financial integrity will reduce bi-lateral credit risk, increase liquidity, and enhance the level of transparency through enforced margin requirements and verified and recorded trades. In his view, this will go a long way to enhance price discovery and reduce systemic risk.

Importantly, the Goldman chief said that financial institutions have a duty to the financial system not to favor customized products when a client’s objective and the market’s interest can be met through an exchange-traded standardized product. Further, when customized derivatives are used they should entail more rigorous capital requirements.

He also said that liquid OTC derivatives should be centrally cleared. Where trading volumes are high enough and price discovery mechanisms can be set up, regulators should encourage exchange trading. In less liquid markets, prompt reporting of aggregated pricing and clearing is necessary to improve transparency.

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