Financial Services and Agriculture Committee Chairs Reach Agreement in Principle on Derivatives Legislation

The derivatives piece of the Obama Administration's proposed legislation to overhaul regulation of the financial markets came closer to fruition as the chairs of the House Financial Services and the Agriculture Committees agreed on the basic principles of derivatives legislation. A joint concept paper released by the chairs helps defuse fears of jurisdictional conflicts as the legislation moves forward. The legislative approach agreed to by Chairs Barney Frank (D-MA) and Collin Peterson (D-MN) bridges the differences between those members who want to completely eliminate the OTC derivatives market and those who think that greater transparency is all that is needed. The principles agreed to by the chairs include harmonized SEC-CFTC regulation, the mandatory clearing of OTC derivatives, limitations on speculation, coordination with foreign regulators and a dispute resolution role for a new Financial Services Oversight Council.

Depending on the underlying asset on which a derivative is based, either the SEC or the CFTC, or potentially both, will oversee the regulation of OTC derivative dealers, exchanges and clearinghouses. The statutory and regulatory powers of the SEC and the CFTC will be harmonized with respect to the OTC derivative market, including registration requirements for dealers. The agencies will have enforcement authority over products under their jurisdiction and joint enforcement authority for any products subject to joint jurisdiction.

The chairs also agreed that the new Financial Services Oversight Council will resolve disputes between the SEC and CFTC over authority over new derivatives products within 180 days. Similarly, the Council will resolve disputes between the SEC and CFTC over joint regulation of derivative products within 180 days. It is envisioned that the Council will include the Fed, the SEC, and the CFTC.

The House leaders also agreed that the legislation will direct U.S. regulators to coordinate with foreign regulators on harmonizing OTC derivative market regulations, including recognized international standards with respect to clearinghouses. In addition, to prevent regulatory arbitrage, the Treasury Department would be authorized to restrict access to the U.S. banking system for institutions of any jurisdiction that Treasury finds permits capital-related standards that are lower than U.S. standards or that promote reckless market activity.

The chairs agreed that derivatives must be cleared by an approved clearinghouse. Exchange trading and trading on electronic trading platforms will be strongly incentivized and encouraged. An exception would be when a regulator determines that the derivatives product is not sufficiently standardized to be cleared, no qualified clearing mechanism exists or when one party in the transaction does not qualify as a major market participant as determined by the appropriate regulator in consultation with the Financial Services Oversight Council. Regulators would be authorized to prohibit or regulate transactions that are not traded on an exchange or cleared.

Primary oversight authority of the credit default swap clearinghouse, ICE Trust, would be shifted from the Federal Reserve Board to a market regulator within six months of the legislation's enactment.

The legislation would require all OTC derivative trades to be reported to a qualified trade repository. The draft legislation would also require that regulators act within 180 days on requests for approval as a clearinghouse, exchange or electronic trading platform.

Under the legislation, appropriate regulators will develop margin and capital requirements to create a strong incentive for dealers and users of derivatives to trade them on an exchange or an electronic trading platform or to have them cleared whenever possible. Higher capital and margin charges will apply to non-standardized transactions that are not exchange-traded or centrally cleared. Regulators would be permitted to authorize the use of non-cash collateral to satisfy margin requirements.

The concept paper sets out two options on speculation. The first is a limitation on speculation prohibiting any purchase of credit protection using a credit default swap unless the party owns the referenced security, the party has a bona fide economic interest that will be protected by the contract or the party is a bona fide market maker. Regulators would be authorized to monitor market activity and impose position limits where necessary.

The second option would be to require confidential reporting to the appropriate regulator of all short interest in credit default swaps by OTC derivatives dealers, investment advisers managing over $100 million, and other entities that are deemed major market participants. In order to prevent abuse, the appropriate regulator would be authorized to impose position limits on market participants and ban the purchase of credit protection using credit default swaps by any non-dealer that is not hedging a risk.