Alert May 19, 2009

Treasury Proposes Framework for Regulating OTC Derivatives

In a letter to Senator Harry Reid (D. Nevada) Timothy Geithner, the Secretary of the Treasury (the “Treasury”) proposed a regulatory framework for regulating over-the-counter (“OTC”) derivatives.  The OTC derivatives market, noted the Treasury currently is largely unregulated.  The Treasury stated that regulation of the OTC derivatives market, including the market for credit default swaps, should be aimed to achieve four broad objectives: (1) preventing OTC derivatives activities from posing systemic risk to the financial system; (2) making the OTC derivatives market more efficient and transparent; (3) preventing market manipulation, fraud and other market abuses; and (4) seeing that OTC derivatives are not marketed to unsophisticated purchasers.

(1)   Preventing activities within the OTC markets from posing systemic risk to the financial system.  The Treasury suggested that the Commodity Exchange Act (the “CEA”) and federal securities laws be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (“CCPs”).  Standardized OTC derivatives generally are “plain vanilla trades” and are characterized by standard contract terms and structures.  The Treasury stated that regulators will need to make certain that CCPs impose strong risk controls and margin requirements, and Treasury also noted that regulators will have to ensure that customized (as opposed to standardized) OTC derivatives are not utilized solely as a means of avoiding use of a CCP.  Customized derivatives are those with characteristics that are transaction specific and are typically complex.  The Treasury further stated that if an OTC derivative is accepted for clearing by one or more regulated CCPs, “it should create a presumption that it is a standardized contract and thus required to be cleared.”

The Treasury further stated that, to control systemic risk, OTC derivatives dealers and other firms with large exposures to specific counterparties should be subject to prudential supervision and regulation, including conservative capital requirements, business conduct standards, reporting requirements and initial margin requirements on counterparty exposures on both standardized and customized contracts.

(2)   Promoting efficiency and transparency within the OTC markets.  The Treasury stated that the CEA and federal securities laws should be amended to authorize the CFTC and the SEC to impose recordkeeping reporting requirements on OTC derivatives and to require maintenance of a documented audit trail.  CCPs and trade repositories, said the Treasury, should be required to make aggregate data on open positions and trading volumes publicly available.  Furthermore, according to the Treasury, CCPs and trade repositories should be required to make a specific counterparty’s trades in positions available on a confidential basis to the CFTC, the SEC and the counterparty’s primary regulators.

The Treasury also stated that it was important that the standardized part of the OTC derivatives market be moved to regulated exchanges and transparent electronic trade execution systems.  According to the Treasury, these changes would allow market participants to see prices and would make markets more transparent.  Moreover, the Treasury added, a system should be developed for timely reporting of trades and prompt dissemination of prices and other trade information.

(3)   Preventing market manipulation, fraud and other market abuses.  The Treasury stated that the CFTC and SEC should be given clear and unimpeded authority to police fraud, market manipulation and other market abuses involving OTC derivatives.  Moreover, 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.” 

(4)   Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.  The Treasury said that, although current law attempts to protect unsophisticated parties against the risk of entering into inappropriate derivatives transactions by limiting the types of counterparties that may participate in these markets, the limits need to be made more stringent.  The Treasury stated that the CFTC and the SEC are reviewing current limits and will make recommendations concerning the tightening of those limits, additional disclosure requirements and/or standards of care for marketing derivatives to less sophisticated counterparties, such as municipalities.

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Furthermore, the Treasury stated that it needed to work closely with regulators in other jurisdictions to promote implementation of complementary systems so that U.S. enhanced controls and regulations are not undermined by the movement of OTC derivatives transactions to less highly regulated jurisdictions.  It is generally recognized that implementation of the Treasury’s proposals, in the aggregate, will, in all likelihood, make it more expensive for issuers, dealers and purchasers to participate in the derivatives market.  The Treasury also stressed that changes to the OTC derivatives market should do nothing that would call into question the enforceability of OTC derivatives contracts.  Finally, the Treasury’s proposal sets forth policy objectives and some details regarding implementation of a program, but many elements of the Treasury’s program will be amended, altered or refined by Congressional actions as well as by the regulators in the development of implementing regulations.