Taking its first step in implementing the Obama Administration’s financial services regulatory overhaul, Treasury Secretary Timothy Geithner announced May 13 a comprehensive regulatory framework for the over-the-counter derivatives market.

In laying out the proposal, Geithner said that 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.” Moving forward, Geithner said the Administration will work with Congress to implement the regulatory plan.

SEC Chairman Mary Schapiro, who accompanied Geithner during the announcement, said that “There is widespread agreement that OTC derivatives, particularly credit default swaps, may have contributed greatly to the financial mess we’re cleaning up today.” Unfortunately, she continued “the lack of clear regulatory authority over this vast market has hindered the ability of regulators to fully understand how this market functions or to ensure that basic standards of fairness are followed.”

Today, Schapiro said, “current federal statutes significantly restrict the ability of financial regulators to obtain reporting or record-keeping in the OTC derivatives market. Yet these are the very types of tools that any regulator would need to identify suspicious trading patterns or better understand systemic risks.” In addition, she said, “central clearing for credit default swaps and other OTC derivatives would bring to this market much-needed transparency.”

The Administration would amend The Commodity Exchange Act (CEA) to give both the SEC and the Commodities Futures Trading Commission (CFTC) regulatory powers over the OTC market.

Treasury’s regulatory reform proposal follows:

Preventing Activities Within The OTC Markets From Posing Risk To The Financial System

Regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk:

The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP).

CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.

For example, if an OTC derivative is accepted for clearing by one o r more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:

Conservative capital requirements

Business conduct standards

Reporting requirements

Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts

  • Promoting Efficiency And Transparency Within The OTC Markets

    To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes:

  • Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:
  • Recordkeeping and reporting requirements (including audit trails).
  • Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
    • CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
    • CCPs and trade repositories must make data on individual counterparty’s trades and positions available to federal regulators.
  • The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
  • The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
  • The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.
  • Preventing Market Manipulation, Fraud, And Other Marke t Abuses

    The Commodity Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and the SEC have:

  • Clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses.
  • Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets.
  • A complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators.
  • Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties

    Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent.

  • The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.