Derivatives Industry Accepts Regulation in Principle with Concerns for Customized Derivatives and Cross-Border Regulation

The derivatives industry generally favors the Obama Administration’s proposal to federally regulate the OTC derivatives markets, but cautioned against forcing customized derivatives on to exchanges and called for globally harmonized regulations to prevent regulatory arbitrage. In testimony before the House Capital Markets subcommittee, ISDA CEO Robert Pickel said that it would be difficult for customized derivatives to trade on an exchange since their terms are determined by the end customer and the dealer to fit a specific need. Even more, mandating that customized derivatives trade on an exchange is likely to result in higher costs and increased risks.

This position found some support from Subcommittee Chair Paul Kanjorski, who noted that some customized derivatives cannot easily fit within a mandatory clearing or exchange trading regime. While acknowledging that subjecting all derivatives to mandatory exchange trading may cast too wide a net, the chair emphasized that the clearing of most products through a central clearing entity seems appropriate and should not impose an undue burden on the affected parties. He also cautioned that carving out too many exemptions in the regulatory reform legislation could create widespread economic harm in the long term. Congress must find a delicate balance, he said.

Rep. Kanjorski also urged the standardization of derivatives contracts wherever possible to promote smoother clearing. The key is clearing, he said, since this opens a window through which regulators and market participants can keep a closer eye on this dark corner of the market and reduces the risks posed through the derivatives contracts collectively.

And even where clearing of contracts proves unfeasible, he continued, transparency can still exist. By mandating the collection of relevant data in a repository, Congress can ensure that regulators maintain access to useful trading information and detect warning signs of systemically risky transactions. Electronic trading also increases transparency. Further, electronic execution streamlines trading, minimizes mistakes, and enhances monitoring of the OTC derivatives markets.

While evidencing a strong preference for clearing and, where appropriate, exchange trading of OTC derivatives, the Administration’s proposed framework does take into consideration the differences among OTC derivatives products and the legitimate needs of market participants that use these products to manage their business risks and adopts a tiered approach to the regulation of OTC derivatives markets.

Agreeing with the Administration’s approach, NYSE Euronext executive VP Thosmas Callahan said that standardized OTC derivatives should be traded on an exchange and cleared through a central counterparty. To the extent that the market for certain standardized derivatives is not liquid enough to survive in an exchange-traded environment, they should be traded through an electronic trading system and cleared through a central counterparty. Customized OTC derivatives that cannot be executed through an exchange or electronic trading system, or cleared through a central counterparty, should still be subject to recordkeeping and reporting requirements with a regulated trade repository.

Industry leaders also expressed concern about the international nature of OTC derivatives and the impact of national legislation. ICE Jeffrey Sprecher said it is vital to recognize that the OTC derivatives markets are international. The majority of large global companies use derivatives, he noted, and they conduct these transactions with U.S. counterparties. Thus, he urged U.S. regulators to work with international regulators to craft a common set of regulatory principles in order to prevent regulatory arbitrage. In his view, the cross-border harmonization of regulation will eliminate the probability that OTC derivatives transactions will flee to jurisdictions where they are least regulated or least restricted.

Similarly, CME Executive Chairman Terrence Duffy urged Congress, when crafting legislation, to take into account the implication that OTC financial markets are global. Trading systems are electronic, banking is international, and every important trader has easy access to markets that are not regulated by U.S. agencies, he noted. Prohibitions or costly impediments to legitimate business activities in the U.S., he added, will divert business to jurisdictions that adopt rational measures to deal with the causes and protection against future financial meltdowns. Thomas Callahan, of NYSE Euronext also observed that the OTC derivatives market is a global market, requiring a global regulatory approach. It would be a mistake for Congress to impose a narrow solution that would effectively designate winners and losers among exchanges, clearing organizations and products and potentially invite retaliation by international regulators.