House committee chairmen produce roadmap to OTC reform

The House Committee on Agriculture has oversight of the Commodity Futures Trading Commission (CFTC) and the House Financial Services Committee oversees the Securities and Exchange Commission (SEC).

The CFTC and the SEC have fought battles over jurisdiction in the past, but the principles would mean dividing up OTC derivatives markets by underlying assets. They would also raise the prospect of joint regulation for products that fall in between. Under the principles, the settlement of any debate concerning the regulation of new products would be resolved within 180 days by the new Financial Services Oversight Council (FSOC). The FSOC is the Obama administration’s proposed systemic risk council, which would be chaired by the Treasury secretary.

The CFTC and SEC’s statutory and regulatory powers over OTC derivatives would be increased to bring them in line with exchange-traded markets, including the ability to impose registration requirements on dealers.

The principles outline at least two different ways in which CDSs could be regulated. One would involve banning the purchase of naked CDSs – or contracts referencing bonds in which the buyer has no economic interest. For buyers of credit derivatives indexes, this would mean holding at least one instrument included in the index. The only exception to this rule would be for “bona fide market makers”, the principles said.

Alternatively, dealers and investment advisers with at least $100 million under management, along with other important market participants as determined by the FSOC, could be required to report all short interest in CDSs to regulators. Regulators would also have the power to ban non-dealers buying naked credit protection, “in order to prevent abuse”, according to the principles. Under both alternatives, regulators would be able to monitor market activity and impose position limits where they see fit.

The two chairmen believe all OTC derivatives trades must be reported to qualified trade repositories, such as the New York-based Depository Trust & Clearing Corporation. The use of clearing houses for OTC derivatives should be made mandatory, the principles said, except for products that are not sufficiently standardised or for which no clearing service exists. Transactions with counterparties that are not considered major market participants by the FSOC would also be exempt from the requirement. Although this means some products may continue to trade OTC without central clearing, the principles would ensure regulators retained the authority to regulate or prohibit them.

Market participants should be economically encouraged to trade on exchanges, the principles said: “Appropriate regulators will develop margin and capital requirements that create a strong incentive for dealers and users of derivatives to trade them on an exchange or electronic trading platform or have them cleared whenever possible.”

For OTC transactions that are not centrally cleared, this could involve significantly higher capital and margin charges, the principles said. Regulators would also be able to authorise the use of non-cash collateral to satisfy margin requirements.

Amid concerns over regulatory arbitrage, the principles said US regulators should co-ordinate their efforts on OTC derivatives with those from other countries. This would include coming up with recognised international standards for clearing houses. Moreover, the Treasury should be allowed to restrict access to the US banking system for firms based in countries permitting dangerously low capital standards, or those promoting “reckless market activity”, the principles said.

Elsewhere, the two chairmen believe regulation of Ice Trust, the CDS clearing house of Atlanta-based IntercontinentalExchange, should be transferred from the Federal Reserve to the CFTC or the SEC within six months of the enactment of any new law covering OTC derivatives.

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