Far-reaching regulation is on its way, and no derivatives transaction will be left unaffected. This is the message that President Barack Obama sent yesterday as Treasury Secretary Tim Geithner outlined the Administration’s proposal for regulation of the derivatives markets in a letter to Senator Harry Reid (D-NV) (link). This proposal seeks to extend federal regulation to cover all over-the-counter (OTC) contracts, with the goal of moving as many transactions as possible on to a central counterparty exchange.

The Obama Administration’s proposal is based on four primary objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting the efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated investors. According to Secretary Geithner, these objectives will be achieved by increasing federal oversight of derivatives markets through expansion of Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) powers and by imposing on the dealer community conservative capital requirements, business conduct standards, reporting requirements, and conservative requirements relating to initial margins on counterparty credit exposures.

Specifically, the proposal advocates amending the Commodity Exchange Act (CEA) and applicable securities laws to require that all “standardized” OTC derivatives be cleared through a regulated central counterparty. These central counterparties are expected to reduce systemic risks through the imposition of significant margin requirements and other risk controls. The administration’s goal is to apply the central clearing principles currently being developed for credit default swaps (link) to the OTC derivatives market as a whole. Secretary Geithner also supports shifting standardized products to trading on regulated exchanges and regulated transparent electronic trade execution systems.

Non-standardized, or “customized,” OTC derivatives would not be forced onto an exchange under President Obama’s plan. However, even without forced central clearing, customized contracts would still face increased regulatory scrutiny under this plan, as the CEA and securities laws would be amended to specifically require publication of aggregate data on open positions and trading volumes in customized OTC contracts, and to allow both the CFTC and SEC to impose recordkeeping and reporting requirements on all OTC derivatives.

Additional regulatory action proposed through yesterday’s letter includes unimpeded authority for the CFTC and SEC to root out fraud and market manipulation, and authorization for the CFTC to set position limits on OTC derivatives that play a significant price discovery function in regulated markets. Finally, the proposal seeks to protect unsophisticated investors by amending the CEA and securities laws to restrict access to derivatives markets, as well as requiring increased disclosures and standards of care by market participants.

Secretary Geithner’s letter follows on the heels of numerous reports by independent and government-affiliated groups regarding the need for additional regulation of the financial system and legislation introduced in both houses of Congress to increase federal oversight of the derivatives markets. The legislative proposals currently on the table include the Derivatives Markets Transparency and Accountability Act of 2009 in the House (link) and the Authorizing the Regulation of Swaps Act in the Senate (link). With the strong backing of the Obama Administration, the outline released yesterday seems sure to gain significant traction in a Congress already poised for a major regulatory overhaul.