CFTC Chairman Gary Gensler has become one of the leading proponents for the regulation of OTC derivatives. In his remarks to the Council of Institutional Investors on April 13, 2010, Mr. Gensler outlined what he views as the key provisions necessary for reform in this area and commented on the existing House and Senate bills.

Recounting the history of derivatives, the Chairman noted that these instruments have been around since the civil war. From the early 1930s until 1980, all derivatives and publicly listed securities were subject to comprehensive oversight by federal regulators. In 1981, this changed with the first over-the-counter derivatives transaction. It was not on an exchange. Rather, it was transacted bilaterally and not subject to regulation.

Transactions in these instruments grew and were at the center of the 2008 financial crisis, Mr. Gensler noted. Derivatives added more leverage to the financial system backed by less capital. AIG, for example, had ineffectively regulated a $2 trillion derivatives portfolio, clearly illustrating the need for reform.

The essential elements of regulation in this area begin with comprehensive regulation of any entity that deals in derivatives. This includes Wall Street banks as well as other non-bank dealers. All standardized over-the-counter derivatives must be brought onto transparent, regulated exchanges or similar trading venues. This will lower risk and improve pricing in the market place. Finally, to further lower risk, all standardized OTC derivatives must be brought into central clearinghouses.

While in the past institutions which dealt in derivatives were regulated, they were not expressly regulated for their derivatives business. This is essential in the Chairman’s view. Regulators must be authorized to set capital and margin requirements for derivatives dealers. This authority should extend to all derivatives dealers.

Another key element of regulatory reform is adding transparency to the markets. Currently, derivatives trade out of sight. This contrasts sharply with regulated futures and securities markets. Indeed, a critical lesson of the 2008 market crisis is that transparency lowers risk in the marketplace. Trading these instruments on exchanges would implement this goal. Exchanges and swap execution facilities also lower risk. Clearing all standardized derivatives through central clearinghouses also helps lower risk.

Some derivatives are not standardized. Rather, they are tailored to the needs of a particular hedger. Those contracts should not be subject to a clearing requirement Mr. Gensler noted. New regulation should ensure that the dealer regulation and capital requirements account for the risks of these transactions. At the same time, it is critical that as many over-the-counter derivatives transactions as possible are moved into the central clearinghouses. This means that there should not be broad exemptions. To ensure fairness and competition, the clearinghouses should have open access. Those clearinghouses should not be governed by parties that might have a conflict of interest or financial stake in the transactions.

These key elements are incorporated into the Senate Banking Committee bill and the current House legislation. Moving forward, it is critical that each of these key elements be incorporated into the final legislation.

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