On March 1, Commodities and Futures Trading Commission (“CFTC”) Chairman, Gary Gensler, spoke to the Institute of International Bankers about over-the-counter (“OTC”) derivatives reform. On March 2, he spoke before the Women in Housing and Finance organization. In his addresses, Mr. Gensler discussed the history of derivative markets, the need for comprehensive regulation in these markets, and the regulatory reforms that should be implemented. The CFTC is charged with monitoring and regulating the futures and commodity options exchanges in order to protect market participants and promote fair trading.
In 1981, the first derivatives transaction took place. Throughout the 1980s, these instruments were tailored one at a time to meet specific risk management requirements of two sophisticated parties—usually a dealer and a corporate customer. Parties negotiated a deal each time they needed to hedge a specific financial risk; they were not widespread public investment tools. Because these transactions did not take place on regulated exchanges, but rather existed purely in company accounting books, the information available to the public about pricing was not readily available. Further, this lack of information made it difficult to understand the magnitude of interconnectedness between financial institutions. Over the next decades, the notion of derivatives as a hedging tool became increasingly popular, causing contracts to be more standardized and easier to negotiate and trade. Upgrades in technology further influenced the popularity of derivatives by facilitating easy electronic trading. At its peak, before the financial crisis, the derivatives market had a notional value of $300 trillion in the U.S., whereas in the 1980s, the notional value of the derivatives market was only $1 trillion.
Since their inception, these financial hedging tools remained largely unregulated. In the aftermath of the financial meltdown, it became known how OTC derivatives can increase risk when unregulated, instead of functioning properly as a risk hedger. Their risk-added is even more dangerous when coupled with the limited availability of pricing information and a lack of transparency. It is for these reasons that Chairman Gensler advocates comprehensive reform of OTC derivatives.
According to Chairman Gensler, there are three main components that will result in effective reform:
- Explicitly Regulate Derivatives Dealers
- Implement Transparent Trading Requirements
- Organize Clearinghouses to Clear Standard Derivatives
Derivative Dealer Regulations. Chairman Gensler believes that having an explicit regulatory framework of derivatives dealers will lower risk. First, the regulations should impose certain capital and margin requirements to mitigate risk to the public. Second, business conduct standards should be put in place to protect against fraud, market manipulation and abuse, which will in turn promote market integrity. Finally, derivatives dealers should have standardized recordkeeping and reporting requirements. Such requirements would bring transparency to the system and provide more accurate pricing information to the public.
Transparency in Trading. Chairman Gensler asserts that trading must be transparent in order to improve how current markets function, create better market liquidity and lower hedging costs. In order to have trading transparency, he advocates that there must be centralized trading venues. These venues would be better equipped to asses and manage risk of OTC derivatives and provide transparency because all derivatives trading would have to have cleared positions based on a reliable market price. The reliable market price would be a by-product of having central trading venues.
Central Clearinghouse for Standard Derivatives. Currently, derivatives are primarily listed on company books, not with a central source, which creates unknown levels of interconnectedness between financial institutions and contributes to the issue of “too big to fail.” Therefore, Chairman Gensler believes that it is imperative to have a central clearinghouse to understand how institutions are connected, because a central clearinghouse would provide transparency about these relationships and reduce interconnectedness of banks since derivatives would flow through the clearinghouse instead of bank balance sheets. It is estimated that 75% of derivatives traded are standard derivatives transactions. Such transactions, because of standardization, can therefore be monitored and cleared though one central clearinghouse. Those derivatives transactions that are highly specialized and tailored would remain outside the scope of the clearinghouse (but within the dealer regulations) and would still be allowed to trade bilaterally. Further, Gensler concedes that there would be other exceptions, but exceptions should remain narrow and explicit.
In closing, Chairman Gensler reiterated the necessity for OTC derivatives regulations because “the central lesson from the crisis is that an interconnected financial system facilitates the spread of risk from institution to institution, threatening the entire economy.”
Currently, the House of Representatives is considering H.R. 3300, the Derivative Trading Accountability and Disclosure Act, which would implement many of the changes Chairman Gensler suggests. The Senate also introduced Senate Bill 3714, Derivatives Trading Integrity Act of 2008, which focused primarily on introducing a regulated exchange for certain types of derivatives. However, that bill was never reconsidered.