Senior Senate Democrat Sponsors Legislation Regulating OTC Derivatives

Draft legislation establishing a comprehensive regulatory framework for derivatives has been introduced by Jack Reed, Chair of the Senate Securities Subcommittee. The Comprehensive Derivatives Regulation Act, S. 1691, would require standardized credit default swaps and other unregulated derivatives to be cleared through a clearinghouse in order to protect the companies and the financial system from the risks posed by these instruments. Importantly, the draft would also authorize regulators to oversee any new derivative product in the future, so dealers can no longer create products that fall into holes in the law. Moreover, S. 1691 would set up strong capital and margin requirements for derivatives dealers and other major market participants and subject them to higher standards for products that are not traded on clearinghouses.

The draft repeals provisions of the Gramm-Leach-Bliley Act and the federal securities laws added to the US Code by the Commodity Futures Modernization Act of 2000. These provisions said that security-based swap agreements are not securities and prohibited the SEC from regulating them as such.

The draft legislation embodies a congressional finding that customized derivative products provide key benefits to some market participants and should be permitted under comprehensive regulation; but that all derivatives activities should be accompanied by appropriate risk management and prudential standards. The legislation seeks to rectify the situation under which OTC derivatives market have grown rapidly while regulators have lacked key information and adequate authority to address systemic and other risks posed by unregulated derivatives trading.

Parties to a standardized security-based swap or security derivative must submit the instrument for clearing to a registered clearing agency. The draft directs the SEC to adopt a rule defining the term ``standardized.’’ The draft mandates the factors the SEC must consider in defining what a standardized derivative is. For example, the SEC must define standardized consistent with the public interest, the protection of investors, the safeguarding of securities and funds, and the maintenance of fair competition among market participants and clearing agencies.

The SEC must also consult with the CFTC and the Fed in defining standardized and maintain comparability, to the maximum extent practicable, with the definition of the CFTC of the term standardized for purposes of section 4r of the Commodity Exchange Act. The SEC must further consider is a clearing agency prepared to clear the security-based swap or security derivative, has effective risk management systems in place.

The Reed draft would subject firms to new conduct requirements to protect investors from abusive practices in the market. It also includes new recordkeeping and reporting requirements to ensure that regulators and investors have broad information about derivatives transactions and positions throughout the financial sector.

In an effort to curtail fraud and manipulation in derivatives markets, the draft would authorize regulators to set position limits and oversee the marketing of products to certain investors. The bill strengthens thresholds in place to ensure that only sophisticated investors are engaging in certain types of trading.

Specifically, the draft bill provides the SEC with jurisdiction over all derivatives that are securities or can be used as synthetic substitutes for securities. This was done, explained Sen. Reed, because without such authority over products that can affect securities markets, the SEC cannot accomplish its mission to protect investors and ensure the integrity and fairness of markets. The draft gives the CFTC jurisdiction over all other derivatives.

The draft would require significant security-based derivatives market participants to register with the SEC and be subject to SEC regulation. The legislation defines a significant security-based derivatives market participants as any person, other than a registered investment company, that is engaged in the business of purchasing or selling security-based swaps or security derivatives for their own account or for others, or making a market in security-based swaps or security derivatives.

As part of rationalizing the sharing of jurisdiction between the SEC and CFTC, the legislation would establish a process for quickly assigning responsibility for new products to the SEC or CFTC so they new instruments do not fall through the cracks. The measure also creates an efficient process for the US Court of Appeals for the District of Columbia Circuit to resolve any differences in views between the agencies that might arise.

The legislation mandates that the SEC and CFTC to jointly issue rules establishing a 90-day process for resolving any disagreement regarding the status of a derivative as security-based. In the determination process, the SEC and CFTC must consider the nature of the derivative, the extent to which the derivative is economically similar to instruments that are subject to regulation by the agencies, and the appropriateness of regulation of the derivative under either the securities laws or the Commodity Exchange Act.

If the SEC and CFTC are unable to agree on the status of a derivative as security-based or commodity-based, either agency may petition the US Court of Appeals for the District of Columbia Circuit for a determination of the status of the derivative under a system of expedited review giving the appeals court 60-days to reach a determination. In making such determination, the legislation specifically instructs the court not to give deference to the views of either the SEC or the CFTC. The draft further mandates that any certiorari petition for Supreme Court review of the appeals court determination of the derivative products jurisdictional status must be filed as soon as practicable after such determination is made.

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