At Chatman House in London the Commodity Futures Trading Commission Chairman said that there will be a comprehensive regulatory framework governing OTC derivatives which should apply not just to CDS but to all dealers and derivatives.
A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, including interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:
· First, there is a need to explicitly regulate derivatives dealers. In so doing, we can set higher capital requirements as well as specific margin requirements for tailored and other bilateral transactions. Without being brought to central clearing, these so-called “bespoke” transactions leave financial institutions with greater risk, make the system more interconnected and justify higher requirements. Capital requirements are essential so that dealers – rather than the taxpayers – are on the hook for the risk they undertake in the derivatives markets. Capital requirements should take into account the unique risks that credit default swaps (CDS) pose. CDS contracts can quickly turn from consistent revenue generators to ruinous losses for the seller of protection. Thus, regulation should account for this “jump to default” exposure by requiring sufficient capital and reserves to cover the CDS in the event of a credit event.
· Second, to promote transparency of OTC derivatives markets to the public, standard over-the-counter derivatives should be traded on exchanges or other regulated trading platforms. The more transparent, the more liquid a marketplace, the more competitive it is and the lower the costs for companies using derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, banks and the U.S. government had no price reference for particular assets – assets that we call “toxic.” Two of the most critical features a clearinghouse needs in order to manage the risk of clearable contracts are reliable pricing data and liquidity of the contract. Trading venues are the best way to bring this essential pricing data and liquidity to the clearinghouses. Regulators should also be able to aggregate position information across trading platforms and set position limits in the OTC derivatives marketplace as we have had authority to do so in the futures markets. Position limiting authority enables regulators to ensure against excessive concentration in the marketplace. Bringing transparency to the regulators through recordkeeping and reporting is essential, but it is not enough. We also must bring real-time transparency to the public through exchanges and other regulated trading venues. Financial reform will be incomplete if we do not achieve public market transparency.
· Third, to further lower risk to the economy, standard over-the-counter derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Clearinghouses in the futures markets have been around since the late-19th century and have functioned both in clear skies and during stormy times – through the Great Depression, numerous bank failures, two world wars and the 2008 financial crisis – to lower risk to the economy. While U.S. taxpayers were not required to cover market exposures on any cleared futures transactions, they had to bail out AIG and others in part to cover uncollateralized and uncleared derivatives contracts.
© CFTC - Commodity Futures Trading Commission
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