As the last piece of the Obama administration’s agenda for the reform of regulatory financial agencies, the U.S. Treasury Department delivered its proposed legislation, titled the “Over-the-Counter Derivatives Markets Act of 2009,” for the regulatory reform of the over-the-counter (OTC) derivatives market to Congress yesterday. The proposed legislation is based on the following objectives of regulatory reform of the OTC derivatives market, enunciated by Treasury this past May:

  1. Preventing activities within the OTC markets from posing excessive risk to the financial system;
  2. Promoting transparency and efficiency of the OTC markets;
  3. Preventing market manipulation, fraud, insider trading and other market abuses; and
  4. Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

To achieve these goals, Treasury proposed legislative language with regard to the following:

Regulating the OTC derivatives markets by:

  • Requiring central clearing and exchange trading of standardized OTC derivatives;
  • Moving more OTC derivatives into central clearing and exchange trading through the implementation of higher capital and margin requirements for non-standardized derivatives;
  • Broadening the definition of standardized OTC derivatives to “be capable of evolving with the markets”;
  • Giving the SEC and CFTC clear authority to prevent market participants to use false customization to avoid central clearing and exchange trading; and
  • Requiring transparency for all OTC derivatives markets by providing all relevant federal agencies with confidential access to OTC derivatives transactions and related positions of individual market participants, and providing public access to aggregated data on open positions and trading volumes.

Regulating all OTC derivative dealers and other major market participants by:

  • Requiring the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives;
  • Requiring OTC derivatives dealers and major market participants that are banks to be regulated by the federal banking agencies, while requiring those that are not banks to be regulated by the CFTC or the SEC;
  • Requiring the federal banking agencies, the CFTC and the SEC to provide strict capital and margin requirements, and to issue and enforce business conduct, reporting and recordkeeping rules, for all OTC derivative dealers and major market participants.

Preventing market manipulation, fraud and other market abuses by:

  • Providing the CFTC and the SEC with authority to deter market manipulation, fraud and other market abuses, and 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.”

Protecting unsophisticated investors by:

  • Tightening the definition of eligible investors that are permitted to engage in OTC derivatives transactions.

For the most part, the Treasury proposal for regulating the OTC derivatives market conceptually parallels the Concept Paper on principles for OTC derivatives legislation released by Congressmen Barney Frank and Collin Peterson a few weeks ago. Both require the strengthening of capital and margin requirements and the mandatory clearing of standardized OTC derivatives, though the congressional proposal provides exceptions from this requirement when one party in the transaction does not qualify as a “major market participant.” The congressional proposal also places greater emphasis on limiting speculation and enhancing oversight of speculative positions, specifically with respect to credit default swaps. Notably, a number of end-user groups have sent a letter to Congressmen Frank and Peterson objecting to the required clearing of OTC derivatives, noting that it will increase their costs. Given this reaction to the congressional proposal, it is likely that the Treasury proposal will face similar objections from industry participants to its mandatory clearing and exchange trading requirements.