The Administration recently released the last piece of draft legislation for its financial reform agenda. The legislation is focused on creating a comprehensive system of regulation for the credit default swap market and all other OTC derivative markets. The draft bill is generally consistent with the framework that the Administration outlined back in June, and the overall thrust of these proposals is to encourage the movement of OTC derivatives transactions from unregulated over the counter markets to regulated exchanges and centralized clearinghouses.
Of all of the draft legislation that the Administration has advanced thus far, I think that this bill is the most far-reaching, in that it essentially creates a new regulatory system where pretty much nothing in the way of government regulation (other than, e.g., capital standards) had existed before. The components of the contemplated regulatory system include:
- Centralized clearing of standardized OTC derivatives through CFTC- or SEC-regulated clearing organizations;
- A requirement that standardized OTC derivatives would be required to be traded on a CFTC- or SEC-regulated exchange or alternative swap execution facility;
- An “encouragement” to use standardized OTC derivatives, with higher capital requirements and higher margin requirements applicable to non-standardized derivatives;
- Transparency through confidential reporting of positions to federal regulators and public data regarding aggregated open positions and trading volumes;
- Federal regulation of any firm dealing in OTC derivatives and firms taking large positions in OTC derivatives;
- Strict capital and margin requirements for all OTC derivative dealers and major market participants through the SEC or CFTC;
- Tools for the SEC and CFTC to prevent manipulation, fraud and abuse; and
- A tightened definition of those eligible investors who may engage in OTC derivatives transactions.
While it is certainly hard to believe that the end of the August recess is almost upon us, it still seems highly likely that Congress will take up derivatives legislation when they get back in town. The Administration’s proposals closely track the agreed-upon guidelines for derivatives legislation reached by Representative Barney Frank (D-MA) and Representative Collin Peterson (D-MN). Further, a number of bills seeking to enhance OTC derivatives regulation have already been introduced in Congress. For example, on the House side, Agriculture Committee Chairman Peterson introduced H.R. 977, which is pending before the House Financial Services Committee. Moreover, H.R. 2454 was introduced by Energy and Commerce Committee Chairman Henry Waxman (D-CA) and includes several provisions concerning OTC derivatives regulation. This legislation was approved by the House on June 26. In the Senate, Agriculture Committee Chairman Tom Harkin (D-IA) introduced S. 272, while other bills with provisions targeting derivatives have been introduced jointly by Senators Carl Levin (D-MI) and Susan Collins (R-ME) (S. 961) and by Senator Ben Nelson (D-NE) (S. 807).
The CFTC Response: Not Quite Far Enough
CFTC Chairman Gary Gensler was apparently not a recipient of Treasury Secretary Geithner’s obscenity-laced tirade a few weeks back, so he felt free to comment to Congressional leaders (as noted in this Bloomberg article) on the Administration’s derivatives legislation, asking lawmakers to, among other things, not adopt exemptions for foreign currency swaps and end users that are not swap dealers or major market participants.
Among other recommendations, Gensler also suggests that Congress not move forward with the mixed swap provisions of the Administration’s draft legislation, which provide for the dual SEC-CFTC regulation of swaps deriving value from both a security and a commodity. Rather, Gensler suggests a system where the applicable regulation follows what the value of the derivative is primarily based on. He also suggests Bankruptcy Code amendments to provide protections similar to those afforded in the futures markets.
The SEC and the CFTC announced last week that they will hold joint meetings to seek public input on the harmonization of market regulation by the two agencies. The first meeting, to occur on September 2, will be held at the CFTC, and the second meeting will be held at the SEC the next day. The two agencies have until the end of September to come up with a report to Congress which identifies conflicts in their regulation of financial instruments and that makes recommendations for harmonizing the regulations.
– Dave Lynn