Thursday, May 14, 2009

Treasury Proposed New Derivatives Rules

From the WSJ:

Under a proposed raft of reforms, regulators could be given authority to force many standard over-the-counter derivatives to be traded on regulated exchanges and electronic-trading platforms. That would make it easier to see prices and make markets more transparent.


The move, the latest step to tighten federal regulation of finance, is designed to address markets such as those for credit-default swaps, which many say exacerbated the financial crisis. Any such moves would require congressional approval.

These rules are obviously targeted at credit default swaps. For those of you who want to get some more basic information on these derivatives, here is a link to the International Swaps and Derivatives Association.

Here is the text from the Treasury's website:

* The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP):

o CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.

o For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

The margin requirements are critical. There have been stories in the press that some companies like AIG were writing naked credit default swaps. This is incredibly stupid, especially at the level AIG was playing.

* All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:

+ Conservative capital requirements
+ Business conduct standards
+ Reporting requirements
+ Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts

The devil will be in the details above. For example, what is a "conservative capital requirement" or "initial market requirement?" We won't know until the law gets written. I'm assuming the reporting requirements will fall in line with standard SEC regulations.

* Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:

+ Recordkeeping and reporting requirements (including audit trails).
+ Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
# CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
# CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators.
+ The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
+ The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
+ The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

The point of the above information is to develop some kind of standard record keeping system which will be used for the industry and regulators. One of the big problems faced over the last few years is we had no idea who had written when contracts to whom. This is critical information what must be maintained.

Again -- this is general information. We'll need to develop the details before we know whether this will work or not.