On May 13, 2009, Secretary of the Treasury Timothy F. Geithner sent a letter to congressional leaders outlining his plan for increased regulatory oversight of the over-the-counter (“OTC”) derivatives market. Mr. Geithner’s plan revolves around the use of regulated central counterparties (“CCPs”), reporting and disclosure requirements, and increased regulation related to market manipulation, capital requirements, and business conduct standards.

Nine years ago, the Commodity Futures Modernization Act of 2000 (the “CFMA”) amended the Commodity Exchange Act (the “CEA”) and clarified that OTC derivatives were excluded from most federal regulation. To the extent that regulation did cover OTC derivatives, it generally was limited to transactions entered into with endusers that did not meet financialbased sophistication standards. Now, the Obama administration, with Mr. Geithner leading the charge, is seeking to rewrite the CEA and other laws to permit and facilitate a robust system of regulating OTC derivatives.

Mr. Geithner’s proposal is designed to meet four 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 parties.”

The CEA and various securities laws would be amended to require regulatory oversight by the Securities and Exchange Commission (the “SEC”), the Commodities Futures Trading Commission (the “CFTC”) and the relevant institution's primary regulator.

Regulated Central Counterparties

Under Mr. Geithner's proposal, all standardized OTC derivatives would be required to be cleared through CCPs, and regulators would be charged with making sure that market participants could not circumvent this requirement by claiming that a standardized trade was instead customized. Regulations would be promulgated to ensure that CCPs impose upon their participants appropriate margin requirements and other risk controls.

The CCPs would track trade volumes and exposures--making the market more transparent and making it easier for regulators to detect market manipulation and other potential problems. Use of the CCPs should also increase market efficiency.

Truly customized OTC derivatives still would be permitted to be traded on a bilateral basis. Such customized transactions, however, would be subject to a “robust and appropriate regime of prudential supervision and regulation.”

Next Steps

While it seems clear that enhanced regulation of OTC derivatives is a fait accompli, it is not clear what form that regulation will take. Last week, Senator Carl Levin and Senator Susan Collins introduced the Levin- Collins Bill, which would allow federal regulation of swaps by effectively repealing the CFMA. Such legislation would be consistent with Mr. Geithner’s proposals as both contemplate multiple regulators, but others have called for a single regulator as a more practical solution.