The United States Senate passed its version of the financial reform bill this past Thursday.  The bill provides comprehensive regulation of the over-the-counter (OTC) derivatives market, which Congress had exempted from regulation in 2000 to prevent OTC derivatives business from migrating to foreign markets with less regulation and to maintain our competitive position.  Many pointed to Congress’ decision in 2000 to exempt such transactions from regulation as a significant factor contributing to the Great Recession of 2008, the country’s worst financial crisis since the Depression era.  The Senate passage of the financial reform places the country one step closer to more stringent regulation of OTC derivatives transactions to rein in financially irresponsible trading in financial products, which as evidenced by the 2008 financial crisis, threaten systemic market failure.
The House passed its version of the financial reform bill in December 2009. The next major hurdle is to reconcile the Senate and House bills. For the most part, the bills contain parallel language, but in the contentious area of clearing requirements for OTC trades, the two bills differ in a manner that may affect exactly which OTC derivatives will be subject to clearing. Both bills require that OTC derivatives clear through a clearinghouses, but only provided that a clearinghouse will accept a trade for clearing. For the most part, clearinghouse can offset standardized trades; however, the more individualized the trade the less likely an offsetting transaction to the customized trade will exist. Many OTC derivatives are customized to meet specific needs of counterparties.  Effectively, the legislation creates the possibility that market participants can continue trading customized OTC derivatives in opaque markets without the benefits of price transparency to which standardized OTC contracts are subject. By exempting such contracts from clearing, the legislation creates an exception which dealers may exploit to avoid price transparency and greater disclosure of their OTC derivatives trades. Gary Gensler, Chairman of the Commodities Future Trading Commission, testifying before the Senate last year expressed concern that dealers and traders might “change a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems.” Â
To their credit, both the Senate and House bill include a evasion prevention section to investigate and to take action if a category or type of OTC derivatives that is mandated clearing is evading the clearing process. The Senate bill goes one step further. It grants rulemaking authority to the CFTC to identify the types of OTC derivatives transactions it believes should be cleared that have not been submitted to clearinghouses for clearing.  The bill enumerates six factors that the CFTC should consider in determining whether certain OTC trades should be submitted to a clearinghouse. Some of the factors include assessing whether the trades are similar to others that have been approved for clearing, whether terms of contracts including price information have been disseminated to third parties, and whether a clearing organization is prepared to clear such trades. The House version of the bill does not include this specific rulemaking authority.  Both bills should be reconciled in favor of providing such rulemaking authority to both the CFTC and Securities and Exchange Commission.   Specific rules directed toward subjecting as many OTC trades as possible to clearing provides greater finality to OTC trades to prevent the type of systemic market failure experienced in 2008. Â
Furthermore, granting such rulemaking authority with enumerated factors prompts regulators to take an aggressive stance towards eliminating trading in opaque markets without price transparency, a necessary component for market efficiency.  Where price transparency exists spreads between bid and ask prices are narrower. In contrast, spreads are wider in opaque markets allowing dealers to earn high profit margins and avoid the competitive process to the detriment of investors.  Supra-competitive pricing creates an inefficient allocation of resources that requires purchasers of OTC derivatives contracts to pay more than the competitive market price and it encourages dealers to assume huge bets and to pile on risk.  It was that type of trading behavior that led the country to brink of financial collapse in 2008.
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