Now that the debate over healthcare reform is at a lull, some focus is finally being placed on one of the causes of the financial crisis: the derivatives market. From the United States to the European Commission to the G-20, regulators and government officials agree there is a need for transparency, central clearing houses and open exchanges.
In the past week U.S. Sen. Chris Dodd, chair of the Committee on Banking, Housing, and Urban Affairs introduced the Restoring American Financial Stability Act, which among many things addresses closing loopholes for over-the-counter derivatives, asset-backed securities and hedge funds. Many naysayers believe the Dodd bill doesn’t stand much of a chance. That includes Ron Insana, a senior analyst at CNBC, who spoke at Financial Executives International (FEI) Current Financial Reporting Issues conference in New York City Monday.
“Financial regulatory reform may be far from a done deal,” Insana said, although he did admit the Dodd bill was one of the most comprehensive bills that addresses systemic risk. That may be true, but only because there is a plethora of proposals. At last check, there are Dodd’s proposal, House Financial Services Committee Chair Barney Frank’s OTC Derivatives Market Act, the Federal Reserve’s plan to OTC credit and interest rate derivatives and the U.S. Treasury’s plans for regulating hedge funds, private equity and derivatives.
The Dodd bill would do a lot of what Frank’s proposal calls for. Regarding derivatives, Dodd’s bill would give the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) authority to regulate OTC derivatives to rein in excessive risk-taking, require central clearing and exchange trading for derivatives where both regulators and clearing houses would have a role in determining which contracts should be cleared (the SEC and CFTC would control which contracts get cleared), requires traders to post margin and capital on uncleared trades, and requires data collection and publication through clearing houses or swap repositories to improve transparency.
It seems as though there has been some collaboration between the House and the Senate on this since the language on who has the power to determine which contracts must be cleared reflects CFTC Chair Gary Gensler’s (See Gensler speech posted on Harvard Law School Forum) change of heart. Originally, he wanted clearing houses to be in charge of those decisions.
“I appreciate Chairman Gensler’s agreeing that we should change the provision of the derivatives bill that he requested that would have put the clearing houses in charge of determining that a trade is clearable.” Frank said on Nov. 6. Four days later, Dodd introduces his legislation with similar language.
Additionally, in a joint Oct. 16 report on regulatory harmonization the SEC and CFTC recommended legislation to enhance CFTC authority over exchange and clearing house compliance with the Commodity Exchange Act. “The CEA should be amended to provide the CFTC with clear authority with respect to exchange and clearing house rules that the CFTC determines are necessary for them to comply with the CEA,” according to the report.
Earlier in September, the Federal Reserve Bank of New York announced it received commitments from 15 major OTC derivatives dealers that they would set specific target levels to expand central clearing for derivatives. The commitments were a follow-up to a June 2, 2009 letter from market participants to regulators. That letter set a Dec. 15, 2009 deadline to begin clearing such contracts, which market participants hope to meet, according to the Fed letter.
For additional information on OTC derivatives markets, Goodwin Procter and The Conference Board Governance Center have some helpful thought leadership. Goodwin Procter has issued a Client Alert analyzing separate bills approved by the House Financial Services Committee and the House Agriculture Committee, each of which would create a new regulatory regime for derivatives trading. The Client Alert also compares these bills to the U.S. Treasury’s proposed OTC derivatives legislation issued in August 2009 (discussed in Goodwin Procter’s August 27, 2009 Client Alert.
The Conference Board’s Corporate Governance Handbook: Legal Standards and Board Practices (Third Edition) addresses the derivatives market in light of the financial crisis. On page 147 in The Role of the Board in Turbulent Times: Assessing Corporate Strategy, states: “The evolving credit crisis is having an impact not only on the capital markets, but also across the general economy. The board of directors should first take the opportunity to re-evaluate the company’s business plan for the coming 12 months. Specifically, it should assess the impact on the business plan of projected cash flow, the limited availability of bank debt, the potential restrictions to the company’s ability to raise equity or debt through the capital markets, and the fixed component of the company’s cost structure.”
Regarding derivatives, it states: “Based on this preliminary review, board members should: Identify the factors that could contribute to an adverse action by rating agencies and design preventive measures. If an adverse ratings action should occur, what implications would there be under the company’s credit facilities, derivatives positions, or other instruments?”