On June 17, 2009, the U.S. Treasury Department (“Treasury”) submitted its report to Congress entitled “Financial Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and Regulation” (“Report”)1. In the Report, the Treasury proposes many reforms to the U.S. financial regulatory system including establishing comprehensive regulation of the financial markets. This memorandum focuses on the Treasury’s proposals to (1) create comprehensive regulation of all OTC derivatives, including credit default swaps (“CDS”), (2) harmonize the regulation of futures and securities and (3) strengthen the supervision and regulation of the securitization markets.
Comprehensive Regulation of All OTC Derivatives
The Treasury’s submitted proposals on comprehensive regulation of all OTC derivatives are, in large measure, a restatement of the policies and objectives set forth by Secretary of the Treasury Timothy Geithner in his letter to Congress on May 13, 2009 (“May 13 Letter”)2. The Report, as was the case in the May 13 Letter, asserts that government regulation of the OTC derivatives markets should be designed to achieve the following four broad objectives:
- preventing activities in OTC derivatives markets, including CDS markets, from posing risk to the financial system;
- promoting the efficiency and transparency of those markets;
- preventing market manipulation, fraud, and other market abuses; and
- ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.
In order to contain systemic risks, the Treasury proposes to amend the Commodities Exchange Act (“CEA”) and the securities laws to require that all standardized OTC derivatives are cleared through regulated central counterparties (“CCPs”). CCPs in turn will be required to impose robust margin requirements and other necessary risk controls, and regulators must ensure that customized OTC derivatives are not used solely to avoid clearing through a CCP. To that end, if an OTC derivative is accepted for clearing by any CCP, a presumption for its standardized nature is created and it should be required to be cleared through CCPs. However, the Report does not elaborate on how standardized OTC derivatives may be distinguished from more bespoke or customized OTC derivatives.
Gary Gensler, the Chairman of Commodity Futures Trading Commission (“CFTC”) provided guidance on this issue in recent testimony.3 Chairman Gensler reiterated that if an OTC derivative contract is accepted for clearing by a fully regulated clearinghouse, then a presumption should exist that such contract documents a standard OTC derivative and thus should be required to be cleared. In addition, he pointed to the following additional factors to consider when determining whether a contract should be treated as a standardized OTC derivative:
- volume of transactions in the contract;
- similarity of the terms in the contract to terms in standardized contracts;
- whether any differences in terms from a standardized contract are of economic significance; and
- extent to which any of the terms in the contract, including price, are disseminated to third parties.
Further, Chairman Gensler testified that the term “OTC derivative” should be defined in the CEA, and the CFTC should be given clear authority over all such instruments.
Increased Supervision and Regulation
To further manage systemic risks to the financial system, the Report reiterates the related tenet from the May 13 Letter that all OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties should be subject to a regime of increased supervision and regulation, including conservative capital requirements (with higher requirements for OTC derivatives that are not cleared through a CCP), business conducts standards, reporting requirements and conservative initial margin requirements that relate to counterparty credit exposures.
Transparency Through Recordkeeping and Reporting
To promote transparency in the OTC derivatives markets, the Report proposes amendments to the CEA and relevant securities laws to authorize the CFTC and the Securities and Exchange Commission (“SEC”) to impose recordkeeping and reporting requirements on all OTC derivatives, including an audit trail. Consistent with guidance offered in the May 13 Letter, these requirements will be satisfied by requiring CCPs and trade repositories to make aggregate data on open positions and trading volumes of standardized and customized OTC derivatives available to the public and to report any individual counterparty’s trades and positions on a confidential basis to the CFTC, the SEC and the institution’s primary regulators.
The Report recites the goal to promote greater market efficiency and price transparency by moving standardized OTC derivatives transactions onto regulated exchanges, by developing a system for timely reporting and dissemination of trade information and by encouraging use of and competition between regulated OTC derivatives markets and regulated exchanges.
Market Integrity and Investor Protection
The Report proposes to give to the CFTC and the SEC clear, unimpeded authority to police fraud, market manipulation, and other market abuses in connection with OTC derivatives, to set position limits on certain OTC derivatives, a request echoed by Chairman Gensler in his June 4 Testimony, and to better protect purchasers of OTC derivatives products.
Harmonizing Futures and Securities Regulatory Landscapes
In the Report, the Treasury suggests that the CFTC and the SEC make recommendations to Congress for changes to the relevant statutes and regulations that would harmonize the regulation of futures and derivatives. Such harmonization would be appropriate because the broad public policy objectives of futures regulation and securities regulation are the same, i.e. protecting investors, ensuring market integrity and promoting price transparency, and because many of the financial instruments governed by these separate regimes are economically equivalent. In addition, the Treasury predicts the following additional benefits will accrue to all relevant parties as a result from such harmonization: (1) less legal disputes about whether certain products should be regulated as futures or securities (which will free significant resources that the regulatory agencies may spend on promoting their policy objectives), (2) greater product innovation due to removal of uncertainty regarding how an instrument will be regulated and (3) greater competition between markets and exchanges as arbitrary jurisdictional distinctions are removed which will in turn result in greater efficiency.4
The Report suggests that, in their efforts at harmonization, the CFTC and the SEC should seek to build a common foundation for market regulation on sufficiently precise principles so that, while allowing room for flexibility and innovation in the marketplace, violations of such principles can be readily identified and subjected to enforcement. The Report explicitly states that these principles should be significantly more precise than the CEA’s current “core principles.”5 The Report states that such harmonization would not require eliminating or modifying laws and regulations relating to futures and options contracts on agricultural, energy and other physical commodity products. The Treasury believes that important protections related to these markets are in place, and such protections must be maintained if not enhanced.
The Report recommends that the CFTC and the SEC complete a report to Congress by September 30, 2009 identifying the different ways that each agency regulates similar types of financial instruments.6 Such differences should be maintained only if they are essential to achieve underlying policy objectives with respect to investor protection, market integrity, and price transparency. If the two agencies cannot come to an agreement by then, the newly formed Financial Services Oversight Council should address such differences and report its recommendations to Congress within six months of its formation7.
Strengthening Supervision and Regulation of Securitization Markets
The Report also includes a number of initiatives aimed at strengthening the regulation and oversight of the nation’s securitization markets. In an effort to address the breakdown of regulation of nonbank mortgage originators and brokers and the general loss of market discipline, the Report included initiatives that are intended to address the following:
- changing the incentive structure of securitization market participants;
- increasing transparency to allow for enhanced due diligence;
- strengthening the performance of credit rating agencies; and
- reducing regulators’ over-reliance on credit ratings.
Revising the Incentive Structure
The Report includes two broad measures to change the incentive structure of securitization market participants: a “skin in the game” proposal and a proposal to tie compensation of market participants to the longer term performance of the securitized assets.
The “skin in the game” proposal calls for federal banking agencies to promulgate rules and regulations that would require originators or sponsors of securitizations to retain five percent of the credit risk of securitized assets. The regulations would prohibit the hedging, either directly or indirectly, of the retained credit risk and would give the regulators authority to identify the form and duration of such risk retention.
The Report also calls for regulators to issue additional regulations to align compensation of market participants with the longer term performance of securitized assets, instead of tying compensation only to the production, creation or inception of the securitized products. The Report suggests that generally accepted accounting principles should be changed to eliminate the immediate recognition of gain on sale by originators at the inception of a securitization transaction and instead require originators to recognize income over time. In addition, the Report recommends proposed changes that would require many securitizations to be consolidated on the originator’s balance sheet and the performance of the assets to be reflected in the originator’s consolidated financial statements.
The Report noted that the SEC is working to improve and standardize disclosure practices of originators, underwriters and credit rating agencies involved in securitizations. To bolster these efforts, the Report suggests that the SEC be given “clear authority” to include ongoing reporting requirements by issuers of asset backed securities (“ABS”). In addition, the Report calls for the standardization of legal documentation related to securitization transactions and the disclosure of loan-level data and the nature and extent of broker, originator and sponsor compensation and risk retention for each securitization.
Strengthening Performance of Credit Rating Agencies
The Report calls for the SEC to continue its efforts to strengthen the regulation of the credit rating agencies (“CRAs”), including the requirement that CRAs maintain policies and procedures for managing and disclosing conflicts of interest. The Report also suggests that CRAs should differentiate credit ratings that they assign to structured credit products from unstructured debt and publicly disclose precisely what risks their credit ratings are designed to assess, including how the risks of structured products differ fundamentally from risks of unstructured corporate debt.
Reducing Regulators’ Over-reliance on Credit Ratings
Lastly, the Report urges regulators to reduce their use of credit ratings in regulations and supervisory practices. When credit ratings are necessary to be used by regulators (including the determination of risk-based regulatory capital requirements), however, the regulators should recognize the differences between structured and unstructured credit products with the same credit rating.