The Obama administration's much-hyped regulatory reform proposals disappointed over-the-counter derivatives dealers and end users yesterday by again failing to provide new details on how OTC markets with mandatory central clearing would operate.
The US Treasury's Financial regulatory reform: A new foundation white paper proposes an ambitious overhaul of almost every element of the US financial regulatory framework, including plans to merge two commercial banking regulators, create a systemic risk council and empower the Federal Reserve with new authority to directly intervene in the affairs of systemically risky institutions.
Most eagerly awaited by derivatives traders, however, were further details of the Treasury's plan to "require clearing of all standardised OTC derivatives contracts through regulated central counterparties (CCPs)" and to encourage OTC customised transactions to be reported to regulated trade repositories.
Remarkably, however, just 11 paragraphs of the 89-page document were given over to the issue, seven of which were reprinted verbatim from Treasury secretary Timothy Geithner's May 13 letter to Senate majority leader Harry Reid.
The only major new detail was the inclusion of a line confirming widely expected plans to levy an additional capital charge upon derivatives positions not cleared with a CCP as a means to encourage end users to clear trades. "Regulatory capital requirements on OTC derivatives that are not centrally cleared also should be increased for all banks and bank holding companies," the new material read.
The white paper also failed to provide further clarification of the criteria regulators will use to determine which standardised OTC trades must be centrally cleared and which will be considered non-standardised and exempt from clearing.
The omission is all the more surprising as sources close to interagency talks held in recent weeks between the Fed, the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation (FDIC) and various industry bodies, confirmed the group submitted specific recommendations to the Treasury on what criteria should be used in making such a determination before a deadline last week.
"The definition of standardisation was a matter of extensive discussion in the interagency meetings, and the group submitted concrete proposals on the issue before last week's deadline, so it's surprising that they haven't made it into this draft, especially given that there was an interagency working group specifically focused on the regulation of OTC derivatives element of yesterday's announcement," remarked a source close to the group's deliberations.
The source reports that the discussions focused extensively on the credit default swap (CDS) market and specifically on the need to specify multiple criteria to ascertain the eligibility of a trade for clearing through a CCP rather than the single and somewhat vague "standardised contract" criterion used in the white paper.
"A vanilla single-name standardised CDS contract with a five-year tenure and 100 basis point coupon may seem appropriate for central clearing, but if its underlying is a barely traded African government bond, that price would be unobservable regardless of how standardised the CDS contract is and inappropriate for clearing. Standardisation is one criterion, but it's not a sufficient condition for acceptance into the clearing house. These issues need to be refined," the source added.
The lack of detail on OTC markets stood in stark contrast to other elements of the white paper, most notably a seismic shake-up of the US regulatory architecture. Among the changes, the Office of Thrift Supervision and the Office of the Comptroller of the Currency will be merged into a new National Bank Supervisor (NBS) to regulate nationally chartered banks, agencies of foreign banks, federally chartered thrifts and thrift holding companies, and to eliminate the potential for regulatory arbitrage by regulated entities.
The President's Working Group on Financial Services will be replaced by a Financial Services Oversight Council (FSOC), fulfilling earlier calls for the creation of a systemic risk council. The body will comprise the Treasury secretary, the chairmen of the Fed, SEC, FDIC and CFTC, and the directors of the NBS, the Federal Housing Finance Agency and a new Consumer Financial Protection Agency.
The FSOC will have its own permanent staff and will be charged with identifying gaps in regulation, resolving jurisdictional disputes between regulators and reporting to Congress annually on potential emerging risks. Furthermore, the council will have the authority to recommend which large institutions should be subject to special oversight and additional capital requirements to account for the threat they pose to the financial stability due to their size, leverage and interconnectedness - referred to in the white paper as Tier I FHC (financial holding company) institutions.
As expected, the Federal Reserve will take on the role of a systemic risk regulator and be charged with supervising systemically risky Tier I 1 FHC firms, including both banks and non-bank entities, a supervisory role that many commentators have suggested might be detrimental to the political independence and neutrality of the central bank.
In identifying systemically risky institutions, the Fed will consider the impact the firm's failure would have on the financial system, its size, leverage and dependence on short-term funding, and its role as a source of credit to households, businesses and state and local governments. Upon the basis of those assessments, Tier I FHC institutions will be obliged to adhere to capital requirements that "reflect the large negative externalities associated with financial distress and [will] be effective under extremely stressful economic conditions" while also hording sufficient capital in placid markets to avoid any pro-cyclical outcomes in volatile periods.
But the Obama administration has not taken decisive action to settle the turf war between the CFTC and the SEC over the regulation of derivatives products. Although many observers had speculated that action could be taken to merge the two entities or amend securities law to place oversight responsibility wholly with one of the agencies, the white paper mandates that the CFTC and the SEC should "make recommendations to Congress for changes to statutes and regulations to harmonise regulation of futures and securities".
In the event that the bad blood between the two agencies prevents them settling their jurisdictional conflicts and presenting a proposed solution to Congress by September 30, their differences will be referred to the FSOC, which will report its recommendations to Congress within six months of its formation.
"The political reality is that both the CFTC and the SEC have major supporters in Congress and trying to make much of a change in their jurisdictional purviews is politically difficult. There isn't consensus and it would slow this reform process down significantly if the Treasury were to attempt to do that. Essentially this is a compromise measure and it will be interesting to see to what extent they can agree on anything," said Robert Claassen, chair of the derivatives and structured products practice at law firm Paul Hastings in California.
New resolution authority governing the orderly dissolution of systemically important firms is also to be introduced, allowing the Treasury to initiate takeover procedures following Presidential consultation, with the recommendation of two-thirds of the Federal Reserve Board and two-thirds of either the FDIC or the SEC, depending on the nature of the firms in question.
Hedge funds "whose assets under management exceed some modest threshold" will be required to register with the SEC and a National Insurance Office will be established within the Treasury to promote national co-ordination of the US insurance industry for the first time in history, although direct regulation remains with the individual states. Proposals to compel originators of securitised financial products to retain an economic interest in securitisations are also to be implemented.
Some observers have concluded that, at least on the issue of derivatives regulation, the Obama administration is quietly scaling back its ambitions. Geithner has dropped plans to "require all non-standardised derivatives contracts to report to trade repositories" altogether, in favour of offering users relief from recordkeeping measures such as audit trails if they record customised trades with repositories.
"The administration now seems comfortable with the OTC derivatives market, but just six months ago there was talk of trying to close down the OTC market altogether and moving it onto exchanges. The commercial reality - aside from what these proposals say - is that there is no way to put standardised contracts on an exchange if they're illiquid," said Claassen.
"The policy-makers are starting to figure this out and we've moved from a stance where every contract would be traded on exchange or through a clearing house to a proposal where it seems the instruments that will be cleared and traded on exchange are the exception. In classic political fashion, the idea is to talk big and to not change much," he added.
See also: Industry opposes mandatory clearing
Merge SEC and CFTC, says former SEC commissioner
Gensler voted in as CFTC chairman
OTC trade repository plan faces hurdles
Geithner calls for law change to force OTC derivatives clearing
Geithner: US will "force all standardised OTC derivatives into central clearing"
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