Obama Administration Legislative Reform Package Likely to Include Comprehensive Federal Regulation of OTC Derivatives Markets

The financial crisis revealed that massive risks in derivatives markets went undetected by both regulators and market participants. But even if those risks had been better known, the SEC and CFTC lacked the proper authorities to mount an effective policy response. Thus, when the Obama Administration unveils its financial regulatory reform proposals, reportedly later this month, they will almost certainly call for the comprehensive federal regulation of the OTC derivatives markets as part of the overall reform package. It would also appear that jurisdiction of the OTC derivatives markets will be divided between the SEC and the CFTC.

The Administration will likely call for amendments to the Commodity Exchange Act and the federal securities laws that will allow market participants to continue to realize the benefits of using both standardized and customized derivatives while achieving key public policy objectives such as transparency and systemic risk amelioration.

The Administration is likely to propose that all dealers in OTC derivative markets and any other firms whose activities in those markets pose a systemic threat should be placed under a strong federal regulatory regime as systemically important firms. In addition, the legislation could mandate that all standardized OTC derivative contracts be cleared through appropriately designed central counterparties subject to comprehensive settlement systems supervision and oversight.

At the same time, all non-standardized customized derivatives contracts would be reported to trade repositories and could be subjected to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices.

Further, in an effort to bring unparalleled transparency to the OTC derivatives markets, the legislation would likely require the central counterparties and trade repositories to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity. The draft could also strengthen participant eligibility requirements and, where appropriate, introduce disclosure or suitability requirements. Further, all market participants may be required to meet recordkeeping and reporting requirements.

In a letter to Senate and House leaders, Treasury Secretary Tim Geithner said that the Administration’s legislative draft will set forth a comprehensive regulatory framework for over-the-counter derivatives, which under current law are largely excluded or exempted from federal regulation. The draft is designed to achieve broad objectives in the regulation of the OTC derivatives markets, such as preventing activities in those markets from posing risk to the financial system and promoting the efficiency and transparency of those markets. At the same time, a primary goal is to prevent market abuses such as manipulation and fraud, and ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties. To achieve these goals, it is critical that similar products and activities be subject to similar regulations and oversight. One likely caveat of the broad reform is that legislation must not call into question the enforceability of OTC derivatives contracts.

In order to contain systemic risks, the Commodity Exchange Act and the federal securities laws would most likely be amended to require the clearing of all standardized OTC derivatives through regulated central counterparties (CCPs). To ensure that this measure is effective, regulators would need to take steps to ensure that CCPs impose robust margin requirements and other necessary risk controls and to ensure that customized OTC derivatives are not used solely as a means to avoid using a central counterparty. For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared. All OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties should be subject to a robust and appropriate regime of prudential regulation.

Key elements of that robust regulatory regime could include conservative capital requirements, business conduct standards, reporting requirements, and conservative requirements relating to initial margins on counterparty credit exposures. Counterparty risks associated with customized bilateral OTC derivatives transactions that would not be accepted by a CCP would likely be addressed by this robust regime covering derivative dealers.

The OTC derivatives markets could be made more transparent by authorizing the CFTC and the SEC, consistent with their respective missions, to impose recordkeeping and reporting requirements, including an audit trail, on all OTC derivatives. Certain of those requirements could be deemed to be satisfied by either clearing standardized transactions through a CCP or by reporting customized transactions to a regulated trade repository. CCPs and trade repositories would be required to, among other things, make aggregate data on open positions and trading volumes available to the public and to make data on any individual counterparty's trades and positions available on a confidential basis to the CFTC, SEC, and the institution's primary regulators.

Market efficiency and price transparency would be improved in derivatives markets by requiring the clearing of standardized contracts through regulated CCPs and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic trade execution systems for OTC derivatives and by requiring development of a system for timely reporting of trades and prompt dissemination of prices and other trade information. Further, regulated financial institutions would be encouraged to make greater use of regulated exchange-traded derivatives. Competition between appropriately regulated OTC derivatives markets and regulated exchanges will make both sets of markets more efficient and thereby better serve end-users of derivatives.

Market integrity concerns would probably be addressed by making whatever amendments to the Commodity Exchange Act and the federal securities laws necessary to ensure that the CFTC and the SEC have unimpeded authority to police fraud, market manipulation, and other market abuses involving all OTC derivatives. The CFTC could also have authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. Central counterparties, trade repositories, and other market participants may be required to provide the CFTC, SEC, and institutions' primary regulators with a complete picture of activity in the OTC derivatives markets to assist those regulators in detecting and deterring all such market abuses.

Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the Administration feels that the limits are not sufficiently stringent. The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the federal securities laws should 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.