On May 13, 2009, Secretary of the Treasury Timothy Geithner submitted a letter to certain key members of Congress in which he outlined the Treasury’s proposal for a comprehensive regulatory framework for OTC derivatives. In his letter, Secretary Geithner expanded on previous congressional testimony and laid out the principles of amending the Commodity Exchange Act (“CEA”), the securities laws and other relevant laws that he considers necessary in order to effectively regulate the OTC derivatives markets.  

Secretary Geithner enumerates four broad objectives for reform:  

  1. preventing activities in the OTC derivatives markets from posing risk to the financial system;  
  2. promoting both efficiency and transparency in these markets;  
  3. preventing market manipulation, fraud and other market abuses; and  
  4. ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.  

The May 13 letter does not contain details of any proposed legislation. The Secretary expresses his hope to collaborate with Congress to “shape U.S. legislation to implement these measures.” However, the letter provides a glimpse into the Treasury’s vision for OTC derivatives regulation by describing the tools with which to achieve the above objectives. In the following, we summarize the concepts for reform outlined in the letter and highlight some of the issues to be considered when gauging the impact of future legislation. As further details emerge, we will continue to update you.  

Central Clearing of all Standardized OTC Derivatives

The May 13 letter states that, in order to contain systemic risks, all standardized OTC derivatives should be required to be cleared through regulated central counterparties (“CCP”). CCPs in turn will be required to impose robust margin requirements and other necessary risk controls. Centralized clearing for customized OTC derivatives will not be mandated, as long as ‘customization’ of OTC derivatives is 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 as a matter of course.  

The proposal to create two categories of standardized and customized OTC derivatives across all asset classes goes beyond previous regulatory and legislative initiatives. Reform proposals thus far have advocated central settlement and clearing for certain OTC derivatives, with a focus on credit default swaps. As discussed in our Reference Guide to the Financial Crisis Rescue Efforts (May 6, 2009), the Federal Reserve and The Securities and Exchange Commission (“SEC”) granted temporary exemptions to each of ICE US Trust LLC (“ICE”) and the Chicago Mercantile Exchange Inc. to provide central clearing of credit default swaps (“CDS”). Both CCPs have committed to impose strict margin requirements and to establish rules and procedures to reduce and manage counterparty risks of their participants. So far, however, their clearing activities are limited to CDS and only ICE actually cleared trades. The May 13 letter provides no further guidance on factors that might distinguish “standardized” from “customized” OTC derivatives. It remains to be seen if Congress will attempt a definition of either category of OTC derivatives or, perhaps more prudently, leave the delineation to the market place and the CCPs. Another aspect of debate is likely to focus on the systemic risk created by concentrating large exposures at a small number of CCPs. Such a decision inherently presumes that CCPs will be better able to assess and maintain satisfactory margin requirements compared to individual market participants.

Increased Supervision and Regulation

To further manage systemic risks, the May 13 letter requires that systemically important participants in the OTC derivatives markets be subject to robust supervision and regulation. The letter specifically states that all “OTC derivatives dealers” and all “other firms whose activities in those markets create large exposures to counterparties” will become subject to regulation and oversight. Key elements of such regulatory regime will include conservative capital requirements, business conducts standards, reporting requirements and conservative initial margin requirements that relate to counterparty credit exposures.

These measures intend to ensure that risks related to customized bilateral OTC derivatives that are not required to be cleared through a CCP will be addressed by increased supervision and regulation of systemically important market participants. While the press release that accompanied the May 13 letter references the “AIG situation,” it is not clear at this point which “other firms” will be deemed sufficiently large to warrant supervision. Market participants other than OTC derivatives dealers should look out for specifications on the degree of counterparty exposure that will subject a market participant other than an OTC derivatives dealer to the proposed regulatory oversight.

Transparency Through Recordkeeping and Reporting

To improve and establish transparency in the OTC derivatives markets, the May 13 letter proposes amendments to the CEA and relevant securities laws to require that all OTC derivatives be subject to recordkeeping and reporting requirements, including an audit trail. The Treasury Secretary believes that some of these requirements could be satisfied by clearing standardized contracts through CCPs and reporting customized contracts to a regulated trade repository. CCPs and trade repositories will be required to make aggregate data on open positions and trading volumes available to the public and to report any individual counterparty’s trades and positions on a confidential basis to the Commodity Futures and Trading Commission (“CFTC”), the SEC and the counterparty’s primary regulator(s).

Increased reporting and public disclosure requirements have long featured as a main tenet of regulatory overhaul of the OTC derivatives markets. It is believed that public disclosure will increase efficiency of the markets by increasing the flow of information among market participants. Disclosure also serves the purpose of enabling regulators to spot excessive leverage or concentrated positions, and to react, before they cause a negative impact to the financial system. Treasury did not detail the scope of required disclosure in the letter. It remains to be seen if new disclosure requirements manage to adequately protect market participants’ legitimate interest in protecting proprietary trading strategies and avoid limiting availability or raising the cost of OTC risk management tools.

Greater Efficiency

The May 13 letter suggests that market efficiency, including price transparency, should be promoted further by moving standardized OTC derivatives transactions onto regulated exchanges or electronic trade execution systems, and by developing a system for timely reporting of trades and prompt dissemination of related trade information (including pricing). Greater efficiency also will be achieved by encouraging competition between regulated OTC derivatives markets and regulated exchanges and by encouraging greater use of regulated exchange-traded derivatives by financial institutions.

Competition among CCPs and derivatives exchanges will be imperative to dispelling concerns about transferring concentrated risk from market participants to a few CCPs that will be ‘too big to fail’. A number of entities in the U.S. and Europe are working toward setting up central clearing and settlement platforms, and two CCPs are operating in the U.S. at this point. The process, however, has highlighted the challenges involved in the design and marketing of central clearing entities that fulfill the expected roles of price transparency and risk mitigation.  

Market Integrity and Investor Protection

The Treasury Secretary makes it clear in the May 13 letter that the CFTC and the SEC should have “unimpeded authority” to police fraud, market manipulation, and other market abuses in connection with OTC derivatives. The CFTC also should have the authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. To better protect purchasers of OTC derivatives products, the CFTC and the SEC have been asked to evaluate the current eligibility criteria for investing in OTC derivatives with a view to the tightening of participation limits and the imposition of additional disclosure requirements or standards of care when marketing derivatives to less sophisticated counterparties such as small municipalities.

We expect to see legislative action initiated soon to implement the objections outlined in Secretary Geithner’s letter (and possibly other objectives as well). The May 13 letter is instructive in showing the direction of future legislation. Most likely, we will see changes to some of the principles introduced into the securities laws and the CEA by the Gramm-Leach- Bliley Act and the Commodity Futures Modernization Act of 2000. In this context, it is helpful that Secretary Geithner stressed the importance of preserving existing legal certainty regarding the enforceability of OTC derivatives contracts. Secretary Geithner also recognized the need to work with foreign authorities to promote implementation of similar measures so that a comprehensive U.S. regulatory framework for OTC derivatives is not undermined by the flight of OTC derivatives to jurisdictions with less stringent regulatory requirements.