USTR Publishes Proposed OTC Legislation

by Glen Shapiro, LawAndTax-News.com, New York

26 August 2009

The US Treasury has published details of the legislation delivered to Capitol Hill which addresses the regulatory reform of over-the-counter (OTC) derivatives. Less than two months since the release of its white paper, "Financial Regulatory Reform: A New Foundation", the proposals have been translated into detailed legislative text with the objective of passing a comprehensive regulatory reform bill by the end of the year.

Enormous unregulated risks built up after the explosive growth and rapid innovation in the markets for credit default swaps and other derivatives, which contributed to the demise of Lehman Brothers and American International Group in the past year and caused severe stress throughout the financial system.

The legislation will require, for the first time, the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives.

OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies. Non-banks will be regulated by the Commodity Futures Trading Commission (CFTC) or Securities Exchange Commission (SEC).

These agencies will be required to provide robust and comprehensive prudential supervision and regulation for all OTC derivative dealers and major market participants which will include:

• enforcing strict capital and margin requirements;
• supervising efficient business conduct, reporting, and recordkeeping (including audit trail); and
• setting position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets.

The objectives of CDS markets and all other OTC derivative markets regulation will be to:

• Guard against activities in those markets posing excessive risk to the financial system arising from the web of bilateral connections among major financial institutions – standardized OTC derivatives must be centrally cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC.
• Promote the transparency and efficiency of those markets – standardized OTC derivatives will be required to be traded on a CFTC- or SEC-regulated exchange or a CFTC- or SEC-regulated alternative swap execution facility. All relevant regulatory agencies will have access on a confidential basis to the detail of OTC derivative transactions and related open positions of individual market participants. In addition, the public will have access to aggregated data on open positions and trading volumes.
• Prevent market abuses – the CFTC and SEC will have clear, unimpeded authority to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivative markets. Detection of these abuses will be made easier with the greater transparency.
• Block OTC derivatives from being marketed inappropriately to unsophisticated parties – the definition of eligible investors that are able to engage in OTC derivative transactions will be tightened to protect individuals and small municipalities.

There will be higher capital requirements and higher margin requirements for non-standardized derivatives, such that a substantial move away from customized products and towards central clearinghouses and exchanges can be expected. The CFTC and SEC will be given clear authority to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.

The total outstanding amount of credit derivatives is thought to be about USD32,300bn, of which USD5,700bn are customized or non-standard contracts, according to the Depository Trust & Clearing Corporation warehouse records.

Gary Gensler, chairman of the CFTC, has already recommended even tighter revisions of the Treasury drafts to remove exemptions for small derivatives dealers, and impose requirements to set aside money to back up trades. “The law must cover the entire marketplace without exception,” Gensler wrote in his letter to various senate committee chairmen.

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