OTC DERIVATIVES REGULATION: A GLOBAL EFFORT
A key part of the Treasury White Paper on financial market reform, discussed here, focuses on increased regulation over the OTC derivatives. Those proposals have engendered significant interest from many market participants. Lobbying reportedly is intense, particularly with respect the huge customized segment of the markets. Those opposing addition regulation cite the benefits derived from derivatives in mitigating risk, while expressing concern about possible increased cost and the prospect of business moving offshore.
On Friday, Treasury Secretary Timothy Geithner provided further details regarding the proposed new regulation in this area in testimony before the House Financial Services and Agriculture Committees. Examination of that testimony in view of concepts under consideration by the European Commission suggests that concerns about business moving offshore may be overstated — regulators around the globe appear to be moving in the same direction on regulatory reform for OTC derivatives.
Secretary Geithner began by acknowledging that derivatives provide substantial benefits to the economy. At the same time, the current market crisis demonstrates that derivatives pose substantial risks to the economy. Those risks stem from the more than six-fold increase in the notional amount or face value of the transactions outstanding over the last decade to almost $700 trillion at the peak of the market in 2008, the lack of transparency in the markets and their interconnectedness and the lack of supervision.
In view of these risks, the proposed regulation, which the Treasury will send to Capitol Hill in coming weeks will focus on achieving four goals: 1) preventing activities in the markets from posing risk to the stability of the financial system; 2) promoting efficiency and transparency; 3) preventing manipulation and abuse; and 4) protecting consumers and investors.
The approach being crafted by Treasury will cover all OTC derivatives “regardless of the reference asset, and regardless of whether the derivative is customized or standardized. In addition, our plan will provide for strong supervision and regulation of all OTC derivatives dealers and all other major participants in the OTC derivatives markets.”
Based on this approach Mr. Geithner outlined seven key points will be incorporated in the proposed legislation:
1) Standardization: Requiring all standardized derivative contracts to be cleared through well-regulated central counterparties and executed on either regulated exchanges or electronic trade execution systems.
2) Broad definition of Standardized: There will be a broad definition of “standardized” which can be evolved over time with the markets. To ensure that the definition is comprehensive, it will be presume that any contract accepted for clearing by a central counterparty is standardized and regulators will be given the authority to police the markets for efforts to evade regulation. In addition, there will be increased capital and margin requirements for counterparties to all customized and non-centrally cleared OTC derivatives to encourage standardization.
3) Capital and margin requirements: All OTC derivatives dealers and all other major OTC derivative market participants will be subject to substantial supervision and regulation. This will include conservative capital and margin requirements and strong business conduct standards.
4) Transparency: There will be full transparency. The public will have access to aggregated data on open positions and trade volume. The SEC and CFTC will impose record keeping and reporting requirements which include an audit trail on all OTC derivatives.
5) Antifraud: The SEC and CFTC will have authority to police the markets for fraud and other market abuses.
6) Regulation of sellers: The SEC and CFTC will tighten the standards that govern who can participate in the OTC derivative markets.
7) International: The Treasury will continue to coordinate with its international counterparts to ensure that other countries have similar regulatory schemes.
The final point of Mr. Geithner’s testimony reflects the fact that Treasury has been coordinating its efforts with other market regulators around the world. The basic principles and building blocks of the Treasury proposals were discussed earlier at the G20 meetings. The same basic principles are outlined in papers prepared by the European Commission which are now under consideration.
Overall, it appears that those who are concerned about a loss of business in this country from additional regulation have little to fear. With other countries moving forward with similar regulatory concepts for the OTC derivatives it appears that regulators are looking to establish a level playing field around the globe.
Mr. Geithner’s testimony is available at: http://www.treasury.gov/press/releases/tg204.htm
Materials regarding the European Commission’s efforts include: “Financial Services: Commission outlines ways to strengthen the safety of derivatives markets, IP/09/1083, 3rd July 2009; Derivatives Markets — frequently Asked Questions, Memo/09/314, 3d July 2009; Communication from the Commission: Ensuring efficient, safe and sound derivatives markets, Com(2009) 332 final; Commission Staff Working Paper, SEC (2009) 905 final, 3rd July 2009. They are available at: