The US Treasury called on Congress on May 12 to amend the Commodities Exchange Act (CEA) to compel clearing of all standardised over-the-counter derivatives through regulated central counterparties (CCPs).
In a letter to Senate majority leader Harry Reid, Treasury secretary Timothy Geithner wrote that financial regulators will need to take steps to ensure CCPs impose robust margin requirements, as well as ensure "customised OTC derivatives are not used solely as a means to avoid using a CCP. If an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardised contract and thus required to be cleared".
Geithner called for further changes to the CEA and other securities laws, including amendments that would allow the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to impose more conservative margin requirements and enforce record-keeping and reporting obligations on all derivatives trades.
Regulators would, however, consider these requirements fulfilled if standardised trades are cleared through approved CCPs and bespoke transactions are reported to a regulated trade repository, such as the New York-based Depository Trust & Clearing Corporation's Trade Information Warehouse.
For their part, CCPs and trade repositories would be obliged to "make aggregate data on open positions and trading volumes available to the public and to make data on any individual counterparty's trades and positions available on a confidential basis to the CFTC, the SEC and the institution's primary regulators".
Leading derivatives dealers will also be subject to conservative capital requirements, business conduct standards and reporting obligations. Legislative amendments will seek to give the CFTC and SEC "clear and unimpeded authority for market regulators to police fraud, market manipulation and other market abuses".
The Treasury also plans to further restrict unsophisticated investors from accessing derivatives markets, in the wake of a raft of scandals across the US where small municipalities have racked up billions of dollars in losses on derivatives contracts they claim were mis-sold - the most infamous being the $3.9 billion loss incurred by Jefferson County, Alabama, on interest rate swaps written against bonds financing sewer reconstruction in the municipality.
Geithner wrote that "price transparency should be improved in derivatives markets by requiring the clearing of standardised contracts through regulated CCPs and by moving the standardised part of these markets on to regulated exchanges". However, he was unclear as to what would constitute a standardised contract.
The proposed amendment to the CEA is the biggest overhaul of the legal framework for OTC derivatives since the Commodity Futures Modernization Act in 2000. This created legal certainty for OTC derivatives by exempting them from the CEA (and therefore the oversight of the CFTC), preserving them as privately negotiated instruments traded off exchange.
Reaction from market participants on the proposals for central clearing has been generally positive. "As long as they do the industry consulting correctly, this could be very good news for the derivatives market as a whole," says Steve Windsor, head of European interest rate product sales at Goldman Sachs in London. "There are a lot of implications for the client base, especially with respect to clearing. But overall, if it leads to a better, more transparent market, that has to be a good thing for all market participants."
The plan to move standardised derivatives contracts on to exchanges, however, has been more controversial. Bankers warn about forcing products with limited liquidity on to bourses, noting it could have a damaging effect on the market and the ability of end-users to manage risks in a tailored fashion.
"It's very important to create an environment where, if certain products are liquid and become suitable for exchanges, they are indeed allowed to go on to exchanges. But there is a reasonably small subset of instruments in the credit markets that fit that description. For a very large part of the credit markets, the liquidity is so spotty and irregular that it will be extremely hard for an exchange-traded contract to take off," says one London-based banker.
Regulatory focus has so far been on the credit default swap (CDS) market. Initiatives to standardise credit derivatives trading have accelerated in the months since the collapse of Lehman Brothers in September 2008, with the establishment of several CCPs in the US and Europe, the conversion to standardised coupons on North American CDS contracts, and the hardwiring of the auction process into credit derivatives documentation under the International Swaps and Derivatives Association's 'big bang' protocol.
"Geithner has been very engaged with the credit derivatives market and that has been very helpful. I think that is a very good development. As long as standards stay sensible and problem-focused, it will make the markets more competitive and easier to deal with for a lot of different people," says the London-based banker.
Peter Madigan and Christopher Whittall.
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