Regulating OTC Derivatives

In a letter to House and Senate leaders yesterday, Treasury Secretary Timothy Geithner proposed amending the “Commodity Exchange Act , the securities laws, and other relevant laws” to enable the government “to regulate the OTC [over-the-counter] derivatives markets effectively for the first time.” A related Treasury press release explains, “As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.”

The Obama Administration therefore proposes changing laws, rules, and practices in order to put in place the following requirements aimed at minimizing risk to the financial system; promoting efficiency and transparency; preventing fraud and market abuses; and protecting against the inappropriate marketing of OTC derivatives to “unsophisticated parties”

  • Clear all standardized OTC derivatives through regulated central counterparties (CCP), which are to impose robust margin requirements and necessary risk controls.
  • Subject OTC derivatives dealers and firms that create large exposures to counterparties to a “robust regime of prudential regulation” to include—conservative capital requirements; business conduct standards; reporting requirements; and initial margin requirements with respect to bilateral credit exposures
  • Authorize the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to impose—recordkeeping and reporting requirements; requirements for trades not cleared by CCPs to be reported to a regulated trade repository; obligations on the CCPs and trade repositories to make aggregate data on open positions and trading volumes publicly available and individual counterparty’s trades and positions available to federal regulators; moving standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems; the development of a system for timely reporting of trades, prices, and other trade information.
  • Give the CFTC and the SEC the authority—to police fraud, market manipulation, and other market abuses; to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets; and to gather the complete picture of market information from CCPs, trade repositories, and market participants for market regulators.
  • Strengthen the laws and participation limits to ensure that OTC derivatives are not marketed inappropriately to “unsophisticated parties.” The CFTC and SEC are reviewing current participation limits to recommend tighter limits or increased disclosure requirements related to marketing derivatives to counterparties “such as small municipalities.”

House Financial Services Committee Chairman Barney Frank (D-MA) and Agriculture Committee Chairman Colin Peterson (D-MN), whose committee has jurisdiction over the CFTC, released a joint statement welcoming the Treasury proposals and committing to working together to achieve “strong, comprehensive, and consistent regulation of OTC derivatives.”

Treasury: Letter to Harry Reid Re: Regulatory Framework for OTC Derivatives (PDF) 

Treasury: Press Release Re: Regulatory Reform for OTC Derivatives