On May 13, 2009, Treasury Secretary Timothy Geithner proposed a comprehensive regulatory framework for over-the-counter (OTC) derivative contracts. This derivatives regulatory framework is an element of the Obama Administration's blueprint for regulatory reform of the financial markets, laid out by Secretary Geithner in congressional testimony in March of this year. The derivatives proposal is intended to achieve four principal objectives: preventing activities in the OTC derivatives markets from posing risk to the financial system; promoting the efficiency and transparency of the OTC derivatives markets; preventing market manipulation, fraud, and other market abuses; and ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.
The proposal was met with cautious optimism by key industry trade organizations and received an enthusiastic response from congressional leaders whose committees have jurisdiction over derivatives. Anyone participating in the derivatives markets needs to be aware of these developments, which are described in more detail below.
Preventing Activities in the OTC Derivatives Markets From Posing Risk to the Financial System
The proposed framework would require that all standardized OTC derivatives be cleared through regulated central counterparties (CCP). The CCPs would be required to impose robust margin requirements and other risk controls to ensure that market participants do not engage in practices that put the financial system at risk.
- Central clearing would be required only for "standardized" OTC derivatives. No definition of a standardized trade is provided, but the proposal notes that if an OTC derivative is accepted for clearing by one or more CCPs, it would be presumed to be standardized. The proposal indicates that steps must be taken to ensure that customized trades are not used solely as a means of avoiding central clearing.
- A principal benefit of central clearing is that a clearinghouse can, through margin requirements, ensure that each party to a derivatives transaction has sufficient capital to cover losses on the transaction. A central clearinghouse could have required AIG, for example, to post collateral for each credit default swap it sold. Margin requirements also would be imposed at the institutional level for customized trades not cleared through a CCP, as noted below.
- Two central clearing counterparties already have obtained regulatory approval for central clearing of credit default swaps in the U.S. Intercontinental Exchange, Inc. was approved by the Securities and Exchange Commission on March 6, 2009, and has already begun clearing credit default swaps, and CME Group, which runs the Chicago Mercantile Exchange, was approved by the Commodity Futures Trading Commission in December of 2008 and by the SEC on March 13, 2009.
Under the proposed framework, major derivatives dealers and other institutions with large counterparty exposures would be subject to additional regulatory oversight to ensure that they do not pose systemic risks to the marketplace. Key elements of the regulatory regime for these entities would include more conservative capital requirements, business conduct standards, reporting requirements, and initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts.
- Establishing margin requirements for customized bilateral OTC derivatives transactions would address counterparty risks for trades that are not required to be cleared through a CCP.
Promoting Transparency and Efficiency Of The OTC Derivatives Markets
- To ensure that regulators have comprehensive and timely information about the positions of participants in all OTC derivatives markets, the proposed framework suggests amending the Commodities Exchange Act (CEA) and the securities laws to authorize the CFTC and the SEC to impose recordkeeping and reporting requirements, including an audit trail, on all OTC derivatives. Information on trades not cleared by a CCP would be reported to a regulated trade repository. CCPs and trade repositories would be required to (i) make available to the public aggregate data on open positions and trading volumes and (ii) make available to federal regulators, on a confidential basis, data on individual counterparties' trades and positions.
- The proposal suggests that market efficiency and price transparency in the OTC derivatives markets be improved by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic trade execution systems and by requiring development of a system for timely reporting of trades and prompt dissemination of prices and other trade information. The proposal also suggests that regulated financial institutions be encouraged to make greater use of regulated exchange-traded derivatives.
Preventing Market Manipulation, Fraud, And Other Market Abuses
The proposal states that the CEA and securities laws should be amended to the extent necessary to ensure that the CFTC and the SEC have clear and unimpeded authority to police fraud, market manipulation, and other market abuses involving all OTC derivatives.
- The SEC already has authority under the CEA and the securities laws to police fraud, market manipulation and certain other market abuses with respect to so-called "security-based swap agreements." The SEC first exercised this authority in April of 2008, when it filed the a civil enforcement action alleging securities fraud in connection with interest rate swaps entered into by Jefferson County, Alabama.1 Earlier this month, the SEC launched the first insider trading enforcement action involving credit default swaps.2
- The proposal would extend the regulators' authority to OTC derivatives that are not security-based swaps and would allocate jurisdiction between the SEC and the CFTC "consistent with their respective missions." This language admits of considerable uncertainty regarding how the jurisdiction would be divided between the two agencies. This question has been the subject of inter-agency tension for many years.
- The proposal recommends authorizing the CFTC to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets.
Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties
- The proposal states that current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that may participate in those markets. The proposal notes that these limits are not sufficiently stringent, and that the CFTC and SEC are reviewing participation limits under current law to recommend how applicable laws should be amended to further restrict participation or impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties, such as small municipalities.
Market Response to the Treasury Proposal
The OTC derivatives community has in some respects anticipated the Administration's proposals, voluntarily taking several recent steps to further standardize certain aspects of credit default swap products and to facilitate clearing of credit default swaps by CCPs.
- The International Swaps and Derivatives Association (ISDA), the trade group that represents the derivatives community, recently made several changes to the standard forms of documentation used for credit default swaps and instituted a "hardwired" auction procedure to resolve credit events (the Big Bang Protocol), in each case with significant industry buy-in.
- The credit default swap "market" has agreed, among other things, to standardize certain pricing and contract date conventions.
- As noted above, two organizations have obtained regulatory approval to clear credit default swaps in the U.S., while other organizations have obtained regulatory approval to clear credit default swaps in Europe.
- While the Administration's proposal — in particular, the proposal to disseminate pricing and other trade information — could result in a narrowing of bid-ask spreads and a reduction in swap dealer profits, ISDA released the following statement on May 13: "This proposal is an important step toward much-needed reform of financial industry regulation," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. Pickel further noted that "ISDA welcomes the recognition of industry measures to safeguard smooth functioning of privately negotiated derivatives and looks forward to working with policymakers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools." On the same day, the Securities Industry and Financial Markets Association (SIFMA) released the following statement by its President and CEO, Tim Ryan: "SIFMA welcomes the Administration's initiative with respect to regulatory reform of OTC derivatives. Our members continue to support efforts to reduce systemic risk, strengthen the infrastructure for derivatives transactions, and improve regulatory transparency. It is important that new regulatory measures preserve the usefulness of derivatives as risk management tools for American businesses and we look forward to working with the Administration to ensure that outcome."
While these cautious responses from the markets are understandable in light of the current turmoil in the financial system, overall, the proposal seems likely to inhibit efficient hedging and therefore could result in greater concentration of risk.
- For example, moving trades to the regulated exchanges would leave many risks unhedged, because standard products simply are not a good fit.
- Moreover, while the proposal presumes that a derivative that is cleared through a central counterparty is a standardized contract, the breadth of the presumption is not clear. For interest rate derivatives, which at first blush might seem to be easily standardized, ISDA publishes definitions for more than 40 different benchmark interest rates denominated in the U.S. dollar alone. ISDA's list of published definitions for benchmark rates in all currencies runs to 57 pages. Interest rate trades can be of varying maturities and for notional amounts that vary over the life of the transaction (based upon, for example, amortization of a related loan). Thus, even in that market, guidance would be necessary to indicate which contracts would be presumed standardized. In other markets, such as the energy markets, highly customized trades are the norm, rather than the exception. Similarly, contracts relating to weather, water rights, and carbon offsets, for example, are also highly customized. The proposal is not clear on how these contracts would be treated.
- The subject of derivatives legislation has drawn significant congressional scrutiny throughout the financial crisis. The unique nature of the derivatives markets and the shared CFTC/SEC role in implementing any reform allow for the House and Senate Agriculture Committees and the House Financial Services and Senate Banking Committees to claim jurisdiction over legislation related to reform. As such, the derivatives marketplace has been the subject of congressional hearings in all four committees, and any legislative product will likely face scrutiny from them all.
- Recent proposed legislation on derivatives includes the following: On January 15, 2009, Senate Agriculture Committee Chairman Tom Harkin (D-IA) introduced the Derivatives Trading Integrity Act of 2009. On February 11, 2009, House Agriculture Committee Chairman Collin Peterson (D-MN) introduced The Derivatives Markets Transparency and Accountability Act of 2009. On May 4, 2009, Sen. Carl Levin (D-MI) and Sen. Susan Collins (R-ME) introduced the Authorizing the Regulation of Swaps Act. Though it is unlikely that any of this legislation will be enacted into law, each bill will serve as a placeholder for positioning in the larger legislative debate.
- Despite the renewed focus on derivatives reform, this issue likely will become wrapped into the larger legislative debate on financial services regulatory reform. Though Congress seemed poised to act incrementally to move various pieces of this reform effort early in 2009, it now appears that a more comprehensive effort may be pursued. In addition to the derivatives issue, Congress faces a set of politically complex issues affecting a wide variety of institutions and products, including systemic risk regulation, resolution authority for non-bank financial institutions, hedge fund regulation and registration, insurance regulation, and myriad other issues. It is likely that Congress will carefully consider and debate each of these areas prior to the passage of significant reform legislation.