It’s time for over-the-counter (OTC) derivatives to move away from a dealer-dominated market to a central marketplace to lower risk and increase transparency, the head of the Commodity Futures Trading Commission (CFTC) said Wednesday.
While the financial crisis of late 2008 “highlighted the need for regulatory reform of the derivatives marketplace,” Chairman Gary Gensler said broad reform of these markets would have been warranted even if the crisis had not occurred (see Daily GPI, May 14, 2009).
“Some opponents of reform argue that derivatives were not at the center of the crisis and should thus not be regulated. I believe, however, that over-the-counter derivatives were at the heart of the crisis,” he said in prepared remarks to the Council on Foreign Relations in New York City.
In the past three decades, the notional value of the OTC derivatives marketplace has gone from less than $1 trillion to more than $300 trillion in the United States, which is “more than 20 times the size of the American economy,” Gensler said. While much of the market has changed, it continues to still be dealer-dominated and unregulated by the CFTC.
OTC derivatives contracts “have become much more standardized” over the years, he said. “In energy and other commodity markets, some estimates are that approximately half could be standardized. With the standardization…the time has come to bring the benefits of a central marketplace that lowers risk and allows market participants to see how contracts are priced.”
Comprehensive reform of OTC derivatives transactions must include three key components, Gensler said. “First, we must explicitly regulate the derivative deals. Leading up to the financial crisis, it was assumed that the banks that deal in derivatives were already regulated…The financial crisis demonstrated that this was a flawed assumption,” he noted.
“Second, regulatory reform must bring sunshine to the opaque [OTC] derivatives markets. Over-the-counter derivatives are traded out of sight of federal regulators and out of sight of market participants. This was at the core of the financial crisis…Bringing transparency to the over-the-counter derivatives markets shifts the information advantage from a small group of derivative dealers on Wall Street to the broader market.
“This not only benefits end-users, but increases competition in the markets by lowering the barriers to entry for additional market makers and liquidity providers,” Gensler said.
“Third, to reduce interconnectedness in the system, standard over-the-counter derivative transactions should be moved into well regulated clearinghouses. Clearinghouses act as a middleman between two parties in a [OTC] derivatives transaction after the trade is arranged. They require derivatives dealers to post collateral so that if one party fails, its failure does not harm its counterparties and reverberate throughout the financial system.
“It is essential that we reduce this risk in the system. Otherwise we could see a repeat of the financial crisis as the risk is externalized and the taxpayers are left on the hook,” he noted.
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