The US Department of the Treasury ("Treasury") has taken another step in the elaboration of a new framework for the regulation of over-the-counter ("OTC") derivatives, which are generally excluded or exempted from regulation under the federal commodities and securities laws currently in effect. The agencies which would be charged with oversight of the OTC derivatives market – the Commodity Futures Trading Commission (the "CFTC") and the Securities and Exchange Commission (the "SEC") – participated with Treasury in a press conference that accompanied the release of a letter from Treasury Secretary Geithner, dated May 13, 2009, to the Congressional leadership (the "Geithner Letter") setting forth the proposal in broad terms.
The general theme of Treasury's proposal is to reconsider many aspects of the Commodity Futures Modernization Act of 2000, which generally excluded OTC derivatives from most regulation under the Commodity Exchange Act (the "CEA") and federal securities laws. While the Geithner Letter lacks many details, it does describe four major policy goals for the regulation of OTC derivatives:
- Prevent activities in the OTC derivatives markets from posing risk to the financial system;
- Promote the efficiency and transparency of those markets;
- Prevent market manipulation, fraud, and other market abuses; and
- Ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties.
One of the proposal’s key points is the differentiation between “standardized” OTC derivatives, for which trading is proposed to require centralized clearing, and “customized” or non-standardized trades, which would not be centrally cleared. For both categories, regulatory scrutiny would be increased, but there would be differences in treatment resulting from differences in the manner of effecting these transactions. The distinction between “standardized” and “customized” OTC derivatives and how to regulate risk while facilitating an appropriate level of competition and product innovation will likely be crucial issues in the debate going forward.
Prudential Regulation and Clearing of Standardized OTC Derivatives
The Geithner Letter is consistent with many existing proposals in that it proposes to require the clearing of certain trade types through central counterparties ("CCPs"), and to require such CCPs to impose, among other things, adequate margin requirements and other risk controls. The main difference is its focus on the clearing of all “standardized” OTC derivatives instead of the clearing of a specific OTC derivative product type (e.g. Credit Default Swaps). While Treasury has not specified the criteria for determining a trade type to be “standardized,” it does state that if an OTC derivative is capable of being cleared, one should presume that it is “standardized.” That being said, the Geithner Letter acknowledges that not all OTC derivatives are “clearable” and that there are some types of OTC derivatives that are too unique or too complex to be centrally cleared.
That distinction is illuminative in that it effectively focuses on whether a particular trade type has become, or can be made, sufficiently commoditized to justify the effort in developing clearing capabilities. Indeed, the Geithner Letter emphasizes that customization of OTC derivatives must not be used solely as a means to avoid using a CCP. The suggested approach apparently reflects a nuanced assessment of relative risk based upon whether a particular trade type has become commoditized. In recognizing that central clearing may not be appropriate for all trade types within a product range, the Geithner Letter appears to leave the door open for further off-exchange product innovation, albeit within a risk controlled environment.
The Geithner Letter envisions that OTC derivatives dealers and all other firms who in the course of their activities incur large exposures to counterparties in these markets will be subject to a robust and appropriate regulatory regime, which must include: (i) conservative capital requirements; (ii) business conduct standards; (iii) reporting requirements; and (iv) conservative requirements relating to initial margins on counterparty credit exposures. (Presumably the reference to "all other firms" includes hedge funds, private equity funds, and other large market participants.) The regulatory regime would include recordkeeping and reporting requirements (including an audit trail) with respect to all OTC derivatives. Certain of these requirements could be satisfied by clearing standardized transactions through a CCP or by reporting customized transactions to a regulated trade repository. CCPs and trade repositories would make aggregate position and volume data available to the public, with data on specific trades and positions available on a confidential basis to the CFTC, SEC and the particular counterparty's primary regulator.
Market Efficiency and Transparency
To enhance market efficiency and price transparency, the Geithner Letter contemplates that standardized OTC derivatives transactions would be moved to exchanges and regulated electronic trading platforms, which would disseminate prices and other trade information to the public. In that connection, the Geithner Letter states that regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives. As noted, customized transactions would be subject to reporting to regulated trade repositories which also would disseminate prices and other trade information to the public. It is unclear which agency would be charged with responsibility for reviewing such reports, as well as supervision and oversight of these regulated trade repositories.
The Geithner Letter asserts that the CFTC and the SEC should have clear, unequivocal authority to police market abuses involving OTC derivatives, including fraud and market manipulation. It states further that the CFTC should have authority to "set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets." It is notable that the CFTC is given equal prominence with the SEC in the new regulatory regime for OTC derivatives.
The Geithner Letter expresses the view that current limits on the type of counterparties who may engage in OTC derivative transactions, i.e., eligible contract participants, as defined in the CEA, are not "sufficiently stringent." It notes further that the CFTC and SEC are reviewing the current eligibility criteria to recommend how the CEA and the securities laws should be amended to tighten these criteria or to impose additional disclosure or other requirements with respect to marketing to less sophisticated entities, such as small municipalities.
Open Issues and Conclusion
The Geithner Letter leaves many details to be worked out and must be viewed in the context of a number of competing legislative proposals circulating in both chambers of Congress. Additionally, the Geithner Letter does not address the precise terms of any legislation that may be introduced. It is helpful that the Geithner Letter specifically acknowledges that the enforceability of OTC derivatives must not be brought into question and that US regulators must complement efforts in other jurisdictions so as to avoid the migration of trading to less regulated jurisdictions.
In this regard, it appears that the Geithner Letter, although vague, will frame the terms of debate regarding any new legislation in this area and may effectively serve to supersede other competing legislative proposals with respect to OTC derivatives.