It has been five years since the first serious regulatory stirrings aimed at the complex and opaque class of over-the-counter derivatives known as credit default swaps. Thanks to the Dodd-Frank Act in the U.S. and gathering momentum on an international scale, a framework for comprehensive OTC market oversight is finally taking shape.
The original alarm was sounded in September 2005 by Timothy Geithner, now U.S. Treasury secretary and then president of the Federal Reserve Bank of New York. He cited mounting systemic risk in a sizable backlog of unconfirmed CDS transactions in the backrooms of more than a dozen major dealer banks.
Geithner extracted commitments from the banks, and ultimately their buy-side clients, to work down the backlog and prevent future problems by automating the trading and processing infrastructure with the help of utilities like the Depository Trust and Clearing Corp. in New York and LCH.Clearnet in London. At the end of 2005, a few months after Geithner’s initial public warning, the notional amount of credit derivatives outstanding stood at $17 trillion and had been roughly doubling every year, according to the International Swaps and Derivatives Association. They would peak at $62 trillion at the end of 2007, just before the global market bubble burst, and have since fallen to $26 trillion as of June 2010, which is about where the market was four years before. ( ISDA Market Survey)
Market participants debate the degree to which CDS and other over-the-counter instruments – CDS notional totals are well below those of interest-rate and currency swaps, which exceed $400 trillion – contributed to the 2008 crash. Although ISDA and other industry advocates can claim to have taken great strides to reduce the risk exposure through processing efficiencies and settlement improvements, the political and regulatory consensus converged on the need to reform derivatives markets through such requirements as product standardization and central clearing.
Years of theoretical and at times contentious discussions took a new turn with the July enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which formally mandated that U.S. securities regulators rein in OTC derivatives. The rulemaking process, well under way at the Commodity Futures Trading Commission and the Securities and Exchange Commission, went into high gear over the last month.
“So far, we have had two public meetings to vote on seven rules,” CFTC chairman Gary Gensler reported in an October 21 speech to the Institute of International Bankers. Five days later, the commission added six more to its docket – out of a total of 30 derivatives-related Dodd-Frank provisions – in the areas of anti-manipulation, disruptive trading practices, rule certification procedures, alternatives to credit ratings, revisions to rules regulating investment of customer funds, and the process for reviewing swaps for clearing. The CFTC is aiming to have all its proposed rules out for public comment by mid-December, allowing for publication of final rules by the July 15, 2011, deadline.
The SEC, for its part, proposed its first OTC derivatives actions on October 13, open for a 30-day comment period, touching on such areas as swaps reporting and clearinghouse ownership and conflicts of interest. Noting there is “a relatively high concentration of market activity through a limited number of dealers who earn significant revenues from their transactions,” SEC chairman Mary Schapiro said. “By creating a structure that would promote more independent voices within clearing organizations and trading venues, this proposed rule is intended to make these entities less susceptible to promoting the interests of a few participants.”
On October 22, the CFTC and SEC held a joint, half-day roundtable to obtain input on CDS clearing issues – an indication of the agencies’ level of cooperation and information-sharing as rulemaking proceeds. Banks, exchanges and clearing organizations represented at the meeting included Deutsche Bank, JPMorgan Chase & Co., CME Group, Eurex, NYSE Liffe, Depository Trust and Clearing Corp. and IntercontinentalExchange’s ICE Trust.
International Action and Coordination
Through the Dodd-Frank Act and CFTC-SEC follow-on activities, the U.S. has become the vanguard and focal point of OTC derivatives regulation. But it is part of a multinational context in which supervisory agencies are intent on clamping down on these markets in a coordinated way.
In mid-October, the International Organization of Securities Commissions, a Madrid-based association that promotes cross-border regulatory cooperation and standards-setting, announced the formation of a task force on OTC derivatives regulation. Hans Hoogervorst, a veteran Dutch government official who is chairman of the IOSCO technical committee and chairman-designate of the International Accounting Standards Board, stated that as various nations consider and adopt laws affecting OTC market oversight, “close consultation with foreign counterparts and the development of consistent standards across jurisdictions . . . could help to promote convergence among IOSCO members and other regulatory bodies, reduce the potential for conflicts of law or regulatory arbitrage and mitigate systemic risk.”
The IOSCO task force agenda calls for a study on exchange and electronic trading for derivatives – as recommended by another international coordinating body, the Financial Stability Board – by the end of January 2011; a report on trade data reporting and aggregation requirements by July; and, building on those two projects, a report by January 2012 setting out “consistent international standards for OTC derivatives regulation in the areas of trading, data reporting, clearing, the oversight of swap dealers and other market participants and, to the extent desirable and feasible, exchange and electronic trading.”
The Financial Stability Board, the body within the Basel, Switzerland-based Bank for International Settlements that will be reporting to the forthcoming G-20 summit meeting in Korea on the progress in post-crisis international financial regulatory coordination in OTC and other areas, issued a 22-page report October 25 listing what it described as “21 recommendations addressing implementation of the G-20 commitments concerning standardization, central clearing, organized platform trading and reporting to trade repositories.”
The communiqué of the June 2010 G-20 summit in Toronto included a pledge “to work in a coordinated manner to accelerate the implementation of over-the-counter derivatives regulation and supervision and to increase transparency and standardization,” and a commitment to trade standardized OTC contracts on exchanges or electronic platforms and clear through central counterparties by the end of 2012.
As stated in the FSB report’s executive summary, “Given the global nature of the OTC derivatives markets, continued international coordination in dealing with ongoing implementation of the G-20 commitments is critical. Work should be taken forward by the relevant standard-setters and authorities to achieve international consistency.”
The FSB OTC Derivatives Working Group is to “monitor implementation of these recommendations and provide an initial progress report” by March 31.
Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.
