Secretary of the Treasury Timothy Geithner delivered a letter to Congress on May 13 proposing the Obama Administration’s comprehensive plan to regulate the over-the-counter (OTC) derivatives market. Securities and Exchange Commission Chairperson Mary Schapiro and Acting Chairman of the Commodity Futures Trading Commission (CFTC) Michael Dunn endorsed the Treasury Secretary’s call to action.

To contain systemic risks, Secretary Geithner proposed amending the Commodity Exchange Act (CEA) and the securities laws to require that all standardized OTC derivatives contracts be cleared through central counterparties (CCP).

Several CCPs have already been approved to clear credit default swap (CDS) transactions. The Obama Administration’s plan, however, would encompass a broader range of derivative financial products.

Four Primary Objectives of Regulation of the OTC Derivatives Markets

The Administration’s plan is designed to (i) prevent activities in the OTC derivatives markets from posing risks to the financial system; (ii) promote efficiency and transparency in the derivatives markets; (iii) prevent market manipulation, fraud and other derivatives market abuses; and (iv) ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties.

The SEC and CFTC have already begun reviewing current laws and regulations to propose amendments that would promote the four primary objectives. For example, both regulators are looking at the participation limits in the current law to recommend how to tighten such limits or to impose additional disclosure requirements and standards of care for marketing derivatives to less sophisticated counterparties. The SEC and CFTC may also recommend they be authorized to impose position limits on counterparties within product-specific markets.

Effect of the Proposed Requirements

The Administration’s plan would apply to derivatives dealers, end-users and any other firm whose activities may result in exposures to counterparties. Secretary Geithner specified that a robust regulatory regime must include (i) conservative capital requirements for counterparties; (ii) business conduct standards for the industry and counterparties; (iii) more stringent reporting and recordkeeping requirements for participants; and (iv) conservative margin requirements for counterparties and CCPs.

Secretary Geithner also advocated enhancing transparency of the OTC derivatives markets by amending the CEA and the securities laws to authorize the CFTC and the SEC to impose new recordkeeping and reporting requirements on all types of entities trading derivatives. CCPs would be subject to additional regulation and required, among other things, to report data on open counterparty trades and trading volumes to the CFTC or the SEC. The proposal is designed to to provide regulators with a more comprehensive and accurate measure of derivatives activity and the risks such activity poses to the entire financial system. Another objective of the proposal is to encourage a robust reporting system to support the price discovery function for these transactions.

In the past six months, regulators have already approved several CCPs to clear CDS transactions. The undertaking outlined in Secretary Geithner’s letter, however, goes much further to promote market efficiency and price transparency by mandating that (i) all standardized OTC derivatives contracts be cleared through regulated CCPs and (ii) the standardized portions of the derivatives markets be moved onto regulated exchanges and transparent electronic trade execution systems.