CFTC Proposes Reforms to Over-The-Counter Derivates Trading Regulation

Statement of Gary Gensler Chairman, Commodity Futures Trading Commission

On June 4th, 2009, Gary Gensler, Chairman of the Commodity Futures Trading Commission, held a hearing before the Senate Committee on Agriculture, Nutrition and Forestry to address the importance of enacting broad reforms to regulate over-the-counter (OTC) derivates.  Gensler emphasized that such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade in order to build and restore confidence in our financial regulatory system.  Below is a summary of the reforms proposed in CFTC hearing:

I.  Comprehensive Regulatory Framework

A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

1.  Lower systemic risks

  • Setting capital requirements for derivative dealers;
  • Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
  • Requiring centralized clearing of standardized swaps; and
  • Requiring business conduct standards for dealers.

2.  Promote the transparency and efficiency of markets

  • Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;
  • Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;
  • Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to the CFTC and other regulators;
  • Requiring centralized clearing of standardized swaps;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;
  • Requiring the timely reporting of trades and prompt dissemination of prices and other trade information

3.  Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits

  • Providing CFTC with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;
  • Providing CFTC with authority to set position limits, including aggregate position limits;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;
  • Requiring business conduct standards for dealers.

4.  Protect the public from improper marketing practices.

  • Business conduct standards applied to derivatives dealers regardless of the type of instrument involved;
  • Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities

To best achieve these objectives, Gensler  recommends implementing two complementary regulatory regimes: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses.

II.  Regulating Derivatives Dealers

The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

 II (a). Capital and Margin Requirements

 The Congress should explicitly require regulators to promulgate capital requirements for all  derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin  requirements, on all transactions by these dealers will help prevent the types of systemic risks  that AIG created. No longer would derivatives dealers or counterparties be able to amass large  or highly leveraged risks outside the oversight and prudential safeguards of regulators.

 II (b).  Business conduct and Transparency Requirements

 Business conduct standards should include measures to both protect the integrity of the market  and lower the risk (both counterparty and operating) from OTC derivatives transactions.

 To promote market integrity, the business conduct standards should:

  • Include prohibitions on fraud, manipulation and other abusive practices
  • Require adherence to position limits established by the CFTC on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets
  • Ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions.
  • Require derivatives dealers to be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions, including retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository
  • Provide transparency of the entire OTC derivates market by making this information available to all relevant federal regulators and making aggregated information on positions and trades available to the public
  • Provide clear authority for regulating and setting standards for trade repositories to ensure that the information recorded meets regulatory needs and the repositories have strong business conduct practices

III.  Regulating Derivates Markets

All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.  Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks.  To fully achieve these objectives, both of these complementary regimes must be enacted – Regulating both the traders and the trades will ensure that we cover both the actors and the actions that may create significant risks. To regulate both derivates and the market itself, the following areas need to be regulated:

a) Central clearing
b) Exchange-trading
c) Position limits
d) Standardized and customized derivates
e) Authority

III (a).  Central Clearing

Central clearing should help reduce systemic risks in addition to the benefits derived from  comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting  of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in  the OTC derivatives market are not cleared, and remain as bilateral contracts between individual  buyers and sellers. In contrast, when a contract between a buyer and seller is submitted to a  clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the  clearinghouse is substituted as the counterparty to the contract and then stands between the  buyer and the seller.

Clearinghouses then guarantee the performance of each trade that is submitted for clearing.  Clearinghouses use a variety of risk management practices to assure the fulfillment of this  guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily  discipline of marking to market the value of each transaction.

The regulations applicable to clearing should require central clearinghouses to:

  • Establish and maintain robust margin standards and other necessary risk controls and measures
  • Have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants
  • Have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a firm
  • Implement rules that allow indirect participation in central clearing

III (b).  Exchange-Trading

Market transparency and efficiency would be further improved by moving the standardized part  of the OTC markets onto regulated exchanges and regulated transparent electronic trading  systems.  Furthermore, a system for the timely reporting of trades and prompt dissemination of  prices and other trade information to the public should be required. Both regulated exchanges  and regulated transparent trading systems should allow market participants to see all of the bids  and offers. A complete audit trail of all transactions on the exchanges or trade execution   systems should be available to the regulators. Through a trade reporting system there should be  timely public posting of the price, volume and key terms of completed transactions.

III (c).  Position Limits

Position limits must be applied consistently all markets, across all trading platforms, and  exemptions to them must be limited and well defined.  The CFTC should have the ability to  impose position limits, including aggregate limits, on all  persons trading OTC derivatives that  perform or affect a significant price discovery function with respect to regulated markets. Such  position limit authority should clearly empower the CFTC to establish aggregate position limits  across markets in order to ensure that traders are not able to avoid position limits in a market  by moving to a related exchange or market. Gensler anticipates that this new authority will  better enable the CFTC to protect the integrity of the price discovery process in the futures  markets and protect the public against fraud, manipulation and other abuses. 

III (d).  Standardized and Customized Derivatives

It is important that tailored or customized swaps that are not able to be cleared or traded on an  exchange be sufficiently regulated. Regulations should also ensure that customized derivatives  are not used solely as a means to avoid the clearing requirement. Genlser proposes that the  CFTC accomplish this in two ways:

  1. Regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps.
  2. Ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems

Additional criteria for consideration in determining whether a contract should be considered to  be a standardized swap contract should include:

  • The volume of transactions in the contract
  • The similarity of the terms in the contract to terms in standardized contracts
  • Whether any differences in terms from a standardized contract are of economic significance
  • The extent to which any of the terms in the contract, including price, are disseminated to third parties

III (e).  Authority

Lastly, to achieve the goals described above, the Commodity Exchange Act should be amended  to provide the CFTC with positive new authority to regulate OTC derivatives. The term “OTC  derivative” should be defined, and the CFTC should be given clear authority over all such  instruments. To the extent that specific types of OTC derivatives might best be regulated by  other regulatory agencies, care must be taken to avoid unnecessary duplication and overlap.
 As new laws and regulations are enacted, the CFTC should be careful not to call into question  the enforceability of existing OTC derivatives contracts. New legislation and regulations should  not provide excuses for traders to avoid performance under pre-existing, valid agreements or to  nullify pre-existing contractual obligations.

IV.  Conclusion

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide the CFTC and other federal agencies with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Today’s complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage.

2 thoughts on “CFTC Proposes Reforms to Over-The-Counter Derivates Trading Regulation

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