Davis Polk & Wardwell Newsflash

Obama Administration Proposes Regulatory Reform for OTC Derivatives

May 14, 2009

On May 13, 2009, the Obama administration asked Congress to approve legislation that would impose a new regulatory oversight structure on over-the-counter (“OTC”) derivatives, which under current law are largely excluded or exempted from regulation.[1] The proposal seeks to implement amendments to the Commodity Exchange Act (the “CEA”) and securities laws to authorize the SEC and the CFTC to oversee and regulate OTC derivatives.  The current proposal is intended to increase transparency and strengthen oversight of the OTC derivatives markets.  Among other things, the proposed framework:

  • requires mandatory clearing of all standardized OTC derivatives through regulated central counterparties (“CCP”);
  • authorizes the CFTC and the SEC to impose recordkeeping and reporting requirements and to require the movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems;
  • grants the CFTC and the SEC “clear, unimpeded authority” to police fraud, market manipulation and other market abuses involving all OTC derivatives; and
  • seeks to tighten limits and impose additional disclosure requirements with respect to marketing of derivatives to less sophisticated counterparties.

Mandatory Central Clearing of Standardized OTC Derivatives Contracts 

The proposal seeks to contain systemic risks by requiring clearing of all standardized OTC derivatives through CCPs.  The proposal charges regulators with ensuring that CCPs impose “robust margin requirements and other necessary risk controls” and to ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.  It explains that if an OTC derivative is accepted for clearing by a CCP, such acceptance should create a presumption that it is a standardized contract and thus is required to be cleared.

In general, the proposal seeks to impose on all OTC derivatives dealers and “all other firms whose activities in those markets create large exposures to counterparties” a “robust and appropriate regime of prudential supervision and regulation.”  This regime would include conservative capital requirements, business conduct standards, reporting requirements and conservative requirements relating to initial margins on counterparty credit exposures.  The proposal does not specify which firms would be subject to such a regime, although the use of this proposal to regulate hedge funds which have been important buy-side participants in the OTC derivatives markets may be likely.

SEC and CFTC Regulatory Roles

The proposal would give authority to both the SEC and the CFTC, among other things, to impose recordkeeping and reporting requirements and movement of standardized trades onto regulated exchanges and to police fraud, market manipulation and other market abuses involving all OTC derivatives.  The proposal does not allocate specific roles to each regulator (except to give the CFTC authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets).  Therefore, legislation resulting from the proposal is likely to serve as the field on which the continuing jurisdictional battle between the SEC and CFTC will be joined.

Protection of Unsophisticated Counterparties

The proposal explains that current limits on the types of counterparties that can participate in OTC derivatives markets are not sufficiently stringent to protect unsophisticated parties from entering into inappropriate derivatives transactions.  The proposal notes that the SEC and the CFTC are reviewing current laws to recommend amendments to ensure that OTC derivatives are not marketed inappropriately to unsophisticated counterparties. 

If you have any questions about the matters discussed in this newsflash, please call your regular Davis Polk contact.

Davis Polk & Wardwell

1. The proposal is set out in a letter from Treasury Secretary Tim Geithner to Congressional leaders and a Treasury Department press release.  CFTC Acting Chairman Michael Dunn and SEC Chairman Mary Schapiro also issued statements, available here and here, at a joint press conference with the Treasury Department announcing the proposal.