In our previous articles on the Regulation of Credit Default Swaps, published on September 26, 2008 and November 28, 2008, we described how regulators in the United States and Canada were addressing the issues of systemic risk and the instability of the financial system attributed to credit default swaps in the aftermath of the financial credit crisis that started in the summer of 2007. While there are many areas in which regulation is seen to be necessary, the largely unregulated privately negotiated over-the-counter (OTC) derivatives market , which includes credit default swaps, is receiving the most attention.
On May 13, 2009, Secretary of the US Treasury Timothy F. Geithner sent a letter to US congressional leaders outlining proposed amendments to the Commodity Exchange Act (CEA), securities laws and other relevant laws that Secretary Geithner believes are needed to enable the US government to effectively regulate the OTC derivatives markets. This update summarizes and briefly comments upon the framework proposed by Secretary Geithner. It also reports on stakeholder reactions to Secretary Geither's proposals.
Objectives of Regulation
The US Treasury Department outlined four main objectives to be achieved by government regulation of the OTC derivatives markets and discussed the related steps to be taken:
1. Preventing activities in OTC derivatives markets from posing risk to the financial system by :
a. amending the CEA and securities laws to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs);
b. ensuring that CCPs impose robust margin requirements and other necessary risk controls; and
c. ensuring that non-standardized OTC derivatives are not used solely as a means to avoid using a CCP.
2. Promoting the efficiency and transparency of OTC derivatives markets by:
a. imposing a "robust and appropriate regime of prudential supervision and regulation" on dealers and firms whose activities in the OTC derivatives markets create large exposures to counterparties, including the establishment of conservative capital requirements, business conduct standards, reporting requirements, and conservative requirements relating to initial margins on counterparty credit exposures;
b. amending the CEA and securities laws to authorize the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to impose recordkeeping and timely reporting requirements on all OTC derivatives transacted, including requiring clearing of standardized derivatives transactions through a regulated CCP and reporting of customized, non-standardized transactions to a regulated trade repository; and
c. requiring CCPs and trade repositories, such as regulated exchanges and regulated transparent electronic trade execution systems for OTC derivatives, to ? among other things ? make aggregate data on open positions and trading volumes available to the public, and to make data on any individual counterparty’s trades and positions available on a confidential basis to the CFTC, the SEC and the institution’s primary regulators.
3. Preventing market manipulation, fraud and other market abuses by:
a. ensuring that the CFTC and SEC have clear, unimpeded authority to police fraud, market manipulation and other market abuses involving all OTC derivatives;
b. ensuring that the CFTC has authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets; and
c. requiring CCPs, trade repositories and other market participants to provide the CFTC, SEC and other regulators with a complete picture of activity in the OTC derivatives market in order to assist regulators in detecting and deterring market abuses.
4. Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties by:
a. amending the CEA and securities laws to tighten the limits on the types of counterparties that could participate in OTC derivatives markets; and
b. amending the CEA and securities laws to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives.
Although US politicians appear to be moving toward establishing a framework for regulation of OTC derivatives, there are still many unanswered questions. One is how a "standardized" OTC derivative will be defined (and who will make that determination). There is a concern that if there is an exclusion from central clearing for non-standardized products, systemic risks will not be properly contained, as, arguably, the higher-risk products often take the form of customized OTC derivatives. However, as mentioned above, those customized transactions would be subject to a "robust and appropriate regime of prudential supervision and regulation," which may be sufficient to address the increased risks. Another unanswered question deals with the practicalities of regulating the OTC derivatives market. While Secretary Geithner’s letter contemplates multiple regulators, others are calling for a single regulator. It appears likely that oversight of OTC derivatives could be split between the SEC and the CFTC.
It should be noted that the proposed framework would treat all OTC derivatives the same. However, there are a multitude of different types of derivatives. The differences are not only based on the underlying asset (i.e., credit, equity, foreign exchange, interest rate, commodities, etc.) but also within each asset type, one can have different structures (i.e., swap, forward, basket swaps, basket forwards, total return, options, etc.). Therefore, drafting regulations that cover all the different types of derivative transactions will be a challenging task.
As discussed in our previous two articles, Alberta, British Columbia and Québec have adopted rules and legislation regulating OTC derivatives. Ontario is still considering its proposed Rule 91-504 dealing with OTC derivatives. However, none of the Canadian provinces have rules in place, nor has any province publicly announced that it is considering rules, which require centralized clearing of OTC derivatives. Furthermore, none of those rules or legislation deals with the extensive recordkeeping and reporting requirements that are being proposed by the US Treasury Department.
Many commentators point to the largely unregulated OTC derivatives market, in particular, credit default swaps, as being the catalyst for the current global credit problems. Whether one agrees or disagrees with that view, it appears that all interested parties would welcome the regulation of OTC derivatives on some level. The Washington Post reported that Secretary Geithner’s letter was warmly received by House Democrats who share oversight of this issue. Even the International Swaps and Derivatives Association, the global trade association that represents participants in the privately negotiated derivatives market, acknowledged that the proposal was "an important step toward much-needed reform of financial industry regulation." However, the ‘devil is in the details,’ and it remains to be seen whether the proposed framework will be effective in minimizing systemic risk, and whether Canadian provinces will use the US regulatory framework as a model for OTC derivatives regulation in Canada. One can expect additional proposals and discussion in the weeks ahead.