Regulation of OTC Derivatives
Part of Anticipated Comprehensive Federal Regulatory Reform
For the last several months, different members of the Senate and House Agriculture Committees and Financial and Banking Services Committees have proposed bills regulating the over-the-counter (OTC) derivatives market. Recently, the Obama Administration has proposed comprehensive Federal regulatory reform that includes a comprehensive framework for the oversight and protection and disclosure of the OTC derivatives market. Certainly, the regulation of systemically important firms and a potential merger of the Securities and Exchange Commission and the Commodity Futures Trading Commission (“CFTC”) would both have an influence on the functioning of the OTC derivatives markets, but Treasury Secretary Timothy Geithner specifically outlined six broad components of this comprehensive framework:
· Regulating OTC derivatives for the first time;
· Instituting a strong regulatory and supervisory regime;
· Clearing all contracts through designated central counterparties;
· Requiring non-standardized derivatives to be subject to robust standards;
· Making aggregate data on trading volumes and positions available; and
· Applying robust eligibility requirements to all market participants.
The first bullet above would abrogate the policy underlying the Commodity Futures Modernization Act of 2000 (the “CFMA”). The CFMA excluded and exempted many financial products, swap agreements and forward contracts from the purview of the CFTC and the Commodity Exchange Act (“CEA”), essentially relying on sophisticated and well-capitalized entities to trade in such markets with anti-fraud and anti-market manipulation provisions of the CEA still applying to protect the marketplace.
Two concepts (in bullet points 3 and 5 above) have been highly discussed in Congress and in the derivatives community: (1) clearing of OTC derivatives through designated central counterparties (CCPs) and (2) more dissemination of information with respect to OTC derivatives. The concept is that forcing OTC derivatives to go through CCPs will allow the government to strongly regulate the CCPs and to have a clearinghouse for information from such CCPs (and such CCPs would be regulated as systemically important firms as well).
This is the same concept used in the Commodity Exchange Act with respect to exchange-traded futures contracts and this concept is also found in the Derivatives Markets Transparency and Accountability Act of 2009 (“DMTA”) that came out of the House Agriculture Committee on February 11th, 2009. The Derivatives Trading Integrity Act introduced by Senator Tom Harkin takes the concept even further by requiring all OTC derivatives to be traded on regulated exchanges.
Many industry players (such as ISDA, the Futures Industry Association, et al.) have noted several potential flaws in forcing OTC derivatives to be cleared or traded on regulated exchanges: (1) moving OTC derivatives onto exchanges would place trillions of dollars of exposure onto the CCPs that would clear OTC derivatives (or regulated futures), which could create a systemic risk at the CCP level (hence the need to regulate CCPs as systemically important firms) or may lead to greatly increased margin requirements on market participants; (2) requiring clearing or trading on exchanges could greatly increase the transactional cost of entering into OTC derivatives with respect to broker fees, clearing costs, margin costs and other fees and expenses that are not currently incurred in the OTC derivatives market (it should be noted that clearing has provided many market participants with a valuable service in dealing with less creditworthy entities); (3) the additional costs and additional regulation could cause certain counterparties to move offshore, which could greatly decrease market liquidity in these markets (thus, potentially increasing costs even more); and (4) the beauty of the OTC derivatives market is the ability to negotiate bilateral terms that work for a particular trading relationship or deal, and those terms will not be able to be negotiated on a regulated exchange (where terms are pre-determined) and will be greatly limited in the clearing context. Presumably, these issues will be addressed in the coming months in determining appropriate regulation of the OTC derivatives markets.
It should be noted that Senator Carl Levin has also introduced a bill (the Prevent Excessive Speculation Act) that is more focused on excessive speculation and price manipulation in agricultural and energy products, and provides for position limits in OTC derivatives markets and stronger reporting requirements. Additionally, other aspects of the Geithner proposal above and of the DMTA include provisions that will require more discussion as to how they will be implemented. It would not be surprising if additional bills and discussion lead to other variations in regulating the OTC derivatives markets or aspects thereof.
We can expect the OTC derivatives market to be regulated in some fashion in the future. We do not have the details of such regulation, but the Obama Administration clearly favors using CCPs as the core of the regulation for clearing and reporting. As Congress debates the merits of such regulation and how it will be implemented and how it might affect the market, the nature of such regulation may change, but one thing is certain: business will not be business as usual after the regulation is promulgated.
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