Gensler criticises reworked rules on OTC derivatives

The chairman of the Commodity Futures Trading Commission (CFTC) has criticised a reworked draft law to regulate over-the-counter derivatives markets, claiming it has weakened the US Treasury's initial stance on mandatory central clearing while threatening to deprive corporate end users of the ability to appropriately hedge risk.

Testifying before the House Committee on Financial Services, CFTC chairman Gary Gensler noted a number of key changes between the initial Over-the-Counter Derivatives Market Act of 2009 proposal released by the Obama administration in August and the discussion draft issued by committee chairman Barney Frank on October 2.

"In the administration proposal, there is a presumption that any contract that would be accepted for clearing must be cleared. While the discussion draft endorses a requirement for central clearing, it shifts from the presumption that all standardised derivatives must be cleared to one where products would be cleared only if required by market regulators," charged Gensler. "The draft then puts the burden on the regulators to determine whether specific contracts, according to specific criteria, should be cleared. I believe it is best for a clearing house that is managing its risk to determine if a particular product should be cleared. The market regulators would oversee those determinations."

Gensler also bluntly stated his opposition to parts of the legislation that could create incentives for corporate end users to switch from bespoke, customised OTC derivatives to contracts. The draft legislation requires all standardised OTC contracts to be cleared through a central counterparty (CCP), while dealers and "major swap participants" would have to hold additional capital for swaps that are not centrally cleared.

In recent months, major corporates have argued customised, bespoke OTC contracts have been used to hedge specific risks on their balance sheets. In contrast, the use of standardised contracts would probably leave them having to manage basis risk.

"I believe such end users should be allowed to fully use customised or tailored contracts to meet their particular hedging needs and these would not need to be centrally cleared. Thus, the only question that remains is, should the end users' standard or clearable contracts be subject to a clearing requirement?" Gensler asked.

Companies have pointed out that central clearing of OTC derivatives would require firms to post initial and variation margin – in many cases for the first time. The collateral requirements could put them under additional pressure in times of stress, they have argued. Rather than forcing firms to funnel large sums of working capital into margin accounts, the CFTC proposes end users be allowed to enter into individual credit arrangements with financial institutions that trade for them.

End users would not be required to post cash or any other form of collateral, but simply work with the clearing firm to determine the most appropriate credit arrangement. Clearing firms would then intermediate credit for end users, while simultaneously bringing their transactions to a clearing house – both lowering risk and accommodating end-user concerns.

Another point raised by Gensler was that the requirement for major swap participants to clear standardised contracts through central counterparties where possible does not go far enough.

"The discussion draft makes trading on regulated exchanges or regulated trading platforms available to swap dealers, but not required. I believe, however, it should be required for all cleared swaps. Market participants and the public would benefit greatly from the transparency and better pricing afforded by regulated exchanges and trade-execution facilities. Thus, the public would get the benefit of transparency, but Congress would address the concern of whether sufficient liquidity exists on all contracts that are cleared for them to be traded on exchanges or trade-execution facilities," Gensler argued.

Committee chairman Barney Frank acknowledged the legislative language has become more modest in its ambition in the latest draft. "It is our intention to have a push in favour of clearing, with a recognition that won't always be possible," he said.

Despite Gensler's comments on shortcomings in the draft, congressmen from both political parties largely complemented the new legislation as a substantial improvement over the previous proposal from the Obama administration, although some problem areas were also highlighted.

"[The] draft derivatives legislation represents a significant improvement over the proposal that the Obama administration submitted to congress in August. However, while the chairman should be commended for addressing several of the serious flaws in the administration's approach, his bill raises a number of issues that require this committee's careful attention," said the leading Republican on the committee, ranking member Spencer Bachus. "The chairman's discussion draft would still require that some OTC products be shifted on to venues like clearing houses and exchanges. The bill also calls on the regulators to classify some actors in the derivatives market as ‘major swap participants'. This vague classification could force thousands of companies to divert hundreds of millions of dollars of capital away from business investment for use as cash collateral," he warned.