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Thursday, March 10, 2011

Derivatives Regulation in the 111th Congress

Mark Jickling
Specialist in Financial Economics

Rena S. Miller
Analyst in Financial Economics

In the wake of the financial crisis and unusual oil price volatility, new attention was drawn to the regulation of derivatives—and particularly toward the unregulated over-the-counter (OTC) derivatives market. What regulatory changes, if any, would reduce risks to the financial system from derivatives trading? A number of bills were introduced in the 111th Congress, and several congressional committees have held hearings. The Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) enacted a sweeping reform of derivatives trading and oversight and brought the unregulated OTC swaps market under the jurisdiction of federal regulators.

The 111
th Congress proposals for reform ran the gamut from requiring all derivatives trading to occur on regulated exchanges—essentially shutting down the unregulated OTC market that exists today—to permitting OTC trading to continue, but with more disclosure and oversight. Some participants in the OTC markets have noted that the lack of transparency is in and of itself an attraction, allowing them to take large speculative positions without other market participants being aware of their identities or trading positions. In the crisis, however, this lack of transparency appears to have exacerbated fears about potential losses faced by financial institutions and made banks less willing to lend. Dodd-Frank requires that all OTC derivatives be reported to swap data repositories, and that key market information be made public.

Before Dodd-Frank, various derivative products were subject to different legal frameworks. The Commodity Futures Trading Commission (CFTC) was the lead federal agency, but the Securities and Exchange Commission (SEC), the Federal Reserve, and other banking regulators also had jurisdictional claims. Under Dodd-Frank, this regulatory complexity continues, with the SEC given jurisdiction over most security-based swaps, the CFTC regulating other swaps, and the other regulators in a variety of consulting roles.

A key OTC market reform is to mandate the use of central counterparties (CCPs)—or clearinghouses—to process derivatives trades and thereby hopefully reduce risk and increase transparency. (Such clearinghouses have long been a standard feature of the regulated futures exchanges.) The Dodd-Frank Act included an exemption from the clearing requirement for nonfinancial end-users, who use derivatives to hedge the commercial risks of their businesses.

Additional proposals focused on new record-keeping or reporting requirements for OTC trades; audit trails; position limits; large trader reporting requirements; and increasing regulatory oversight of trading. An additional important question, for which Congress’s tools may be limited, is how to ensure regulatory harmonization with other international markets, so as to avoid a “race to the bottom” in derivatives regulation.

The Dodd-Frank derivatives provisions are summarized in CRS Report R41398, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives, by Mark Jickling and Kathleen Ann Ruane. This report summarizes other derivatives legislation that was considered but not enacted by the 111
th Congress, and it provides background on the derivatives market. .

Date of Report: March 3, 2011
Number of Pages: 43
Order Number: R40646
Price: $29.95

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