Congress Looks Determined to Regulate OTC Derivative Trading

In a near party-line vote, the House Committee on Financial Services approved 43-26 the “Over-the-Counter Derivatives Markets Act of 2009,” which would give the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) unprecedented authority to regulate over-the-counter (“OTC”) derivative transactions.

Credit default swaps and other derivative instruments are considered by many to be among the catalysts for last year’s financial crisis. The legislation, initiated by the Obama administration, would give the CFTC and the SEC new tools to regulate such transactions.

In an effort to make OTC derivative transactions more transparent, the bill, among other things, would require “standardized” derivative trades to be cleared and (in some cases) traded on an exchange and would impose new recordkeeping and reporting requirements on traders. Derivatives used to hedge against fluctuations in interest rates, foreign currency or commodity prices, however, would be eligible for exemptions.

The legislation also establishes a framework for the regulation of swap markets, dealers and major swap participants. The bill gives the CFTC and the SEC joint rulemaking authority over OTC derivative markets. In situations where the two Commissions cannot agree, the bill gives the Treasury Department the authority to issue final rules.

In addition, the bill contains an express antitrust savings provision to clarify that the new legislation is not intended to impede or prevent the Justice Department or the Federal Trade Commission from prosecuting traders who violate the antitrust laws. By expressly permitting the application of the antitrust laws to conduct already policed by the CFTC and SEC, the savings provision is likely to cause consternation and uncertainty for traders trying to decide whether a particular transaction is permitted under the different and potentially conflicting regulatory regimes.

A press release issued by the Financial Services Committee described the key provisions of the legislation as follows:

Clearing

The legislation provides a mechanism to determine which swap transactions are sufficiently standardized that they must be submitted to a clearinghouse. For transactions that are clearable, central clearing is a requirement when both counterparties are either dealers or major swap participants. Clearing organizations must seek approval from the appropriate regulator — either the CFTC or the SEC — before a swap or class of swaps can be accepted for clearing.

Transactions in standardized swaps that involve end-users are not required to be cleared. Such end-user transactions must, however, be reported to a trade repository, as would any customized derivative transactions.

Mandatory Trading on Exchange or Swap Execution Facility

A standardized and cleared swap transaction where both counterparties are either dealers or major swap participants must either be executed on a board of trade, a national securities exchange or a “swap execution facility” — as defined in the legislation. If none of these venues make a clearable swap available for trading, the trading requirement would not apply. Counterparties would, however, have to comply with transaction reporting requirements established by the appropriate regulator. The legislation also directs the regulators to eliminate unnecessary obstacles to trading on a board of trade or a national securities exchange.

Registration and Regulation of Swap Dealers and Major Swap Participants

Swap dealers and major swap participants must register with the appropriate Commission and dual registration is required in applicable cases. Capital requirements for swap dealers’ and major swap participants’ positions in cleared swaps must be set at greater than zero. Capital for non-cleared transactions must be set higher than for cleared transactions. The prudential regulators will set capital requirements for banks, while the Commissions will set capital requirements for non-banks at a level that is “as strict or stricter” than that set by the prudential regulators.

The regulators are directed to set margin levels for counterparties in transactions that are not cleared. The regulators are not required to set margin levels in transactions where one of the counterparties is not a dealer or major swap participant. In cases where an end-user is a counterparty to a transaction, any margin requirements must permit the use of non-cash collateral.

Reporting and Public Disclosure of Swap Transactions 

Reporting and recordkeeping is required for all over-the-counter derivative transactions. Clearing organizations must provide transaction information to the relevant Commission and a designated trade repository. Swap transactions that are not cleared and for which no trade repository exists, must be reported directly to the relevant Commission. The legislation also provides for public disclosure of aggregate data on swap-trading volumes and positions — in a manner that does not disclose the business transactions or market position of any person. Large positions in swaps must also be reported directly to regulators.

Swap Execution Facilities

Swap execution facilities, or facilities for the trading of swaps that are not boards of trade or national securities exchanges, must register with the relevant regulator as a swap execution facility (“SEF”). SEFs must also adhere to core regulatory principles relating to enforcement, anti-manipulation, monitoring, information collection and conflicts of interest, among others. The CFTC and SEC are required to prescribe joint rules governing the regulation of swap execution facilities. A Commission may exempt an SEF from registration if it is subject to comparable, comprehensive supervision and regulation by another regulator.

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The House Agriculture Committee is working on its own version of the bill. Though the two bills are largely similar, there are some important differences. For example, unlike the joint rulemaking approach envisioned by the Financial Services Committee’s bill, the Agriculture Committee’s bill seeks to assign “primary” rulemaking authority to either the CFTC or the SEC depending on the subject matter of the swap. Under this approach, if a particular swap is predominately securities-related, the SEC would be primarily responsible for drafting the applicable rules; otherwise the CFTC would have primary responsibility. The Agriculture Committee’s bill also includes foreign exchange swaps and forwards in definition of “swap,” while the Financial Services Committee’s bill would exempt such transactions.

Lawmakers are expected to begin working on the Agriculture Committee’s version of the bill in the next few weeks. If passed, the two versions will need to be reconciled before the final bill is sent to the full House for a vote.

In a statement issued after the bill’s approval, CFTC Chairman Gary G. Gensler called the Financial Services Committee’s bill “a significant step” toward “comprehensive regulatory reform of the over-the-counter derivatives marketplace lowering risk and promoting transparency,” but noted that “substantive challenges remain.” Unsatisfied with some of the exemptions in the Financial Services Committee’s version of the bill, Mr. Gensler pledged that he will continue to work with legislators to ensure that the final version “covers the entire marketplace without exception.”