Obama Administration Proposes Broad Federal Regulation of OTC Derivatives

The Obama Administration has proposed legislation to provide for a comprehensive and detailed regulatory regime for all OTC derivatives. The legislation would be designed to achieve the four broad goals of preventing systemic risk to the financial system, promoting transparency, preventing market manipulation, and protecting unsophisticated parties. To achieve these goals, it is critical that similar products and activities be subject to similar regulations and oversight.

The legislation would amend the Commodity Exchange Act and the federal securities laws to require the clearing of all standardized OTC derivatives through regulated central counterparties (CCP). For their part, the central counterparties would be required to maintain robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP. The legislation would provide that the acceptance of an OTC derivative for clearing by a fully regulated CCP should create a presumption that it is a standardized contract and thus required to be cleared.

Further, all OTC derivatives dealers and all other firms who create large exposures to counterparties would be subject to a robust regime of prudential supervision and regulation, which will include conservative capital requirements, business conduct standards, reporting rules, and initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts.

In order to promote transparency, the legislation must ensure that regulators have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets. This goal would be accomplished by authorizing the CFTC and the SEC to impose recordkeeping and reporting requirements, including audit trails. Trades not cleared by a CCP will have to be reported to a regulated trade repository.

In addition, CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public; and make data on individual counterparty's trades and positions available to federal regulators. The legislation should also mandate the development of a system for the timely reporting of trades and the prompt dissemination of prices and other trade information. It would also encourage regulated institutions to make greater use of regulated exchange-traded derivatives. The Administration believes that competition between regulated OTC derivatives markets and regulated exchanges will make both sets of markets more efficient and thereby better serve end-users of derivatives.

In order to effectively police fraud and market manipulation, the CFTC and SEC must be authorized to to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets. The regulators must also have a complete picture of market information from CCPs, trade repositories, and market participants so that the SEC and CFTC can detect and deter market abuses.

The legislation must also set stringent limits to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. To that end, the CEA and the federal securities laws must be amended to 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.

Two bills regulating OTC derivatives were reported out of the House and Senate Agriculture Committees earlier this year. The House Derivatives Markets Transparency and Accountability Act of 2009 was sponsored by Ag Committee Chair Collin Peterson. The bill was referred to the House Financial Services Committee. There is a companion bill in the Senate introduced by Senator Tom Harkin, Chair of the Agriculture Committee. The Harkin bill, S 272, would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges.

In the wake of the Administration’s proposal, Chairman Peterson and House Financial Services Chair Barney Frank said that they would work closely together to pass legislation providing for the strong, comprehensive and consistent regulation of OTC derivatives.

The Administration’s proposal comes against the backdrop of a growing global consensus favoring a central counterparty for OTC derivatives, including credit default swaps. Earlier this year, Elizabeth King, SEC Associate Director for Trading and Markets, said that a well-regulated and prudently managed central counterparty for credit default swaps has the potential to significantly reduce counterparty credit risks to market participants.

In remarks at the Security Traders Association mid-winter meeting, the SEC official also emphasized that a CCP can also reduce systemic risks by preventing the failure of a single market participant from having a disproportionate effect on the overall market.

A global CCP is becoming more likely as a consensus builds that this is an important aspect of market reform. Recently, French central bank chief Christian Noyer endorsed the initiative to create a central counterparty for credit default swaps, calling the initiative crucial to financial stability. Similarly, the European Central Bank welcomes the initiatives to create central counterparties and expects to see concrete results. Former NY Fed President Gerald Corrigan told the House Agriculture Committee that there should be a single dedicated global CCP for credit default swaps.