New proposals on over-the-counter derivatives aim to reduce risk, promote efficiency, prevent fraud and ensure that such derivatives are not marketed to unsophisticated parties.
On May 13, 2009, the U.S. Department of the Treasury proposed several reforms of the over-the-counter (OTC) derivatives markets. Treasury Secretary Timothy Geithner, along with the chairmen of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), jointly unveiled the proposal.
These reforms are designed to address what are perceived to be weaknesses in the OTC derivatives market that contributed to the lack of confidence in financial institutions generally. Although significant reforms of the OTC derivatives market were proposed well before the beginning of the current crisis1, regulators and market participants moved slowly to adopt those proposed reforms. The OTC derivatives market was recently reported to be close to US$684 trillion in notional size.
Current exempt status
Regulation of futures and other derivatives occurs under the Commodity Exchange Act (the CEA) and federal securities laws. Unless there is an applicable exemption, futures and other derivatives are required to be treated on a regulated exchange. The principal current exemptions for OTC derivatives were adopted over 8 years ago during the Clinton administration as part of the Commodity Futures Modernization Act of 2000. The key exemption for OTC derivatives is found in Section 105 of the CFMA, which provides that, subject to certain limited exceptions, nothing in the CEA governs or applies to any agreement, contract or transaction in a commodity (other than an agricultural commodity) if the agreement, contract or transaction is:
- entered into only between persons who are eligible contract participants at the time they enter into the agreement, contract or transaction;
- subject to individual negotiation by the parties; and
- not executed or traded on a trading facility.
Current law seeks to protect unsophisticated parties from entering into inappropriate OTC derivatives transactions by limiting the types of counterparties that are eligible to participate in those markets (for example, the definition of “eligible contract participants”).
Goals of the Treasury proposal
The goals of the Treasury’s proposal are as follows:
- prevent activities in the OTC derivatives markets from posing risks to the financial system (i.e., reduce systemic risk);
- promote efficiency and transparency (i.e., facilitate better price discovery and more accurate mark-tomarket valuation of OTC derivative positions);
- prevent market manipulation, fraud and other abuses; and
- ensure that OTC derivatives are not marketed to unsophisticated parties.
Outline of the Treasury proposal
Create a comprehensive regulatory framework that applies to all OTC derivatives.
Uniformity across global markets
Promote the implementation of similar measures around the world to ensure a level playing field.
Trading of standardized contracts on regulated central clearing counterparties
Amend the CEA and the securities laws to require that all standardized OTC derivatives clear through regulated central counterparties (CCP). A well-known example of a CCP is the Options Clearing Corporation. CCPs will be required under the proposal to impose robust margin requirements and other necessary risk controls.
Ensure that customized OTC derivatives are not used to avoid using a CCP
Give authority to regulators to ensure that customized OTC derivatives (which will not be required to clear through CCPs) are not used solely as a means to avoid clearance through a CCP. For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, a presumption will be created that it is a standardized contract and thus required to be cleared through a CCP.
Supervision and regulation of dealers
Subject all OTC derivatives dealers and all other firms that create large exposures to counterparties to a robust regime of prudential supervision and regulation, which will include:
Conservative capital requirements
In particular, capital charges for customized derivatives (due to counterparty credit risk not present with a regulated CCP) will likely be materially higher than standardized derivatives that clear on a CCP.
Business conduct standards
Business conduct standards currently apply to brokers and dealers in securities, both under federal securities laws and also under rules of self-regulatory organizations such as FINRA (Financial Industry Regulatory Authority
- the successor to the NASD). Similar rules would likely be adopted to cover the activities of OTC derivatives dealers.
The CFTC and the SEC would have the authority to impose:
- record keeping and reporting requirements (including audit trails);
- requirements for all trades not cleared by CCPs to be reported to a regulated trade repository:
- CCPs and trade repositories would be required to make aggregate data on open positions and trading volumes available to the public;
- CCPs and trade repositories would be required to make data on individual counterparty trades and positions available to federal regulators;
- the movement of standardized trades on to regulated exchanges and regulated transparent electronic trade execution systems;
- the development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information; and
- the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.
Regulators have discussed imposing a system similar to TRACE, the bond price reporting system of FINRA, on OTC derivatives. FINRA adopted TRACE in 2002. TRACE reportedly reduced bank profits in the corporate bond market by almost half after its adoption and implementation.
Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts
Imposing initial margin requirements will control the amount of leverage that may be implicitly incurred under an OTC derivative.
Preventing market manipulation, fraud and other market abuses
This would involve amending the CEA and federal securities laws to ensure that the CFTC and the SEC have:
- clear and unimpeded authority for market regulators to police fraud, market manipulation and other market abuses;
- authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets; and
- a complete picture of market information from CCPs, trade repositories and market participants.
Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties
This requires a review of current law to recommend how the CEA and the federal securities laws should be amended to impose:
- additional disclosure requirements (i.e., risk disclosures similar to those that currently apply to the trading of futures and other similar products on regulated commodity exchanges); and
- standards of care (i.e., suitability requirements) with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.