Obama Administration Unveils Legislation to Regulate Derivatives, Including Credit Default Swaps

The Administration has proposed detailed legislation regulating the OTC derivatives markets. As part of the first-time federal regulation, credit default swap markets and all other OTC derivative markets would be subject to comprehensive regulation in order to guard against activities in those markets posing excessive risk to the financial system and promote the transparency and efficiency of those markets. The legislation would also empower the SEC and CFTC to prevent market manipulation, fraud, insider trading, and other market abuses. In addition, it would block OTC derivatives from being marketed inappropriately to unsophisticated parties.

The Obama Administration proposes, for the first time, the federal regulation of credit default swaps as part of the regulation of OTC derivatives. Credit default swaps are contracts which insure a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade. Naked credit default swaps are those swaps that are merely a wager on the viability of an institution or financial instrument without requiring the corresponding underlying risk from the failure of those institutions or instruments.

The comprehensive regulation would include the regulation of OTC derivative markets and all OTC derivative dealers and other market participants. To reduce risks to financial stability that arise from the web of bilateral connections among major financial institutions, the legislation would require standardized OTC derivatives to be centrally cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC. To improve transparency and price discovery, standardized OTC derivatives would be required to be traded on a CFTC- or SEC-regulated exchange or a CFTC- or SEC-regulated alternative swap execution facility.

Through higher capital requirements and higher margin requirements for non-standardized derivatives, the legislation would encourage substantially greater use of standardized derivatives and thereby facilitate the substantial migration of OTC derivatives onto central clearinghouses and exchanges. Further, the legislation proposes a broad definition of a standardized OTC derivative that will be capable of evolving with the markets.

The measure creates a presumption that an OTC derivative that is accepted for clearing by any regulated central clearinghouse is standardized. The CFTC and SEC would be authorized to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.

Transparency is a hallmark of the legislation. To that end, all relevant federal financial regulators would have access on a confidential basis to the OTC derivative transactions and related open positions of individual market participants. In addition, the public would have access to aggregated data on open positions and trading volumes.

The legislation would require, for the first time, the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives. Under the legislation, OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies, while OTC derivative dealers and major market participants that are not banks will be regulated by the CFTC or SEC.

The federal banking agencies, CFTC, and SEC would be required to provide comprehensive prudential regulation, including strict capital and margin requirements, for all OTC derivative dealers and major market participants. The legislation authorizes the CFTC and SEC to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivative markets.

The CFTC and SEC would be able to set position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. The full regulatory transparency that the legislation would bring to the OTC derivative markets will assist regulators in detecting and deterring manipulation, fraud, insider trading, and other abuses. The CFTC and SEC would be required to issue and enforce strong business conduct, reporting, and recordkeeping (including audit trail) rules for all OTC derivative dealers and major market participants.

The financial crisis revealed that massive risks in derivatives markets went undetected by both regulators and market participants. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the CFTC. Similarly, the CFMA limited the SEC's authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.

This lack of regulation led to disastrous consequences. Many institutions and investors had substantial positions in credit default swaps, swaps tied to asset backed securities, complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated of market participants. At the same time, excessive risk taking and poor counterparty credit risk management by many banks saddled the financial system with an enormous unrecognized level of risk.

When the value of the asset-backed securities collapsed, the danger became clear. Individual institutions believed that these derivatives would protect their investments and provide return, even if the market went down. But, during the crisis, the sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the swaps and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed.