Development of OTC Derivatives Infrastructure Continues Apace

James Hamilton, J.D., LL.M., Principal Analyst, CCH Federal Securities Law Reporter; and CCH Derivatives Regulation Law Reporter.

Vetted by the New York Federal Reserve Board, major market participants and their regulators continue to make significant progress in developing a robust infrastructure for OTC derivatives. While collective international efforts have increased operational efficiency and created greater transparency, noted NY Fed President William Dudley, recent events underscore the need for more progress in reducing risk in the OTC derivatives market. Banks and buy-side firms still need to make considerable improvements to both risk management and the design of the OTC derivatives markets, he said. At a recent meeting, prospective steps were outlined to strengthen the OTC derivatives market infrastructure and enhance risk management practices, consistent with the priorities of the President’s Working Group on Financial Markets and the U.S. Treasury’s framework for regulatory reform.

Since June 2008, the industry has taken a number of steps to improve the OTC derivatives market infrastructure, including establishing central counterparty platforms to reduce counterparty credit and operational risk. Market participants have also taken steps to expand the information publicly available about the credit default swap markets. The Depository Trust & Clearing Corporation began releasing weekly aggregate volume data on the CDS market in November of 2008. Moreover, dealers have begun to provide a range of pricing information to the public via a vendor portal. Market participants have also significantly reduced levels of outstanding credit default swap trades via multilateral trade terminations to lower outstanding notional amounts, reducing counterparty credit exposures and operational risk.

Market participants and regulators have agreed to implement further improvements in the OTC derivatives market infrastructure. For example, the hardwiring of an auction-based settlement mechanism for credit default swaps will be implemented. Market participants also agreed to strengthen the operational improvement roadmap presented to regulators in October 2008 with additional aggressive benchmarks for moving to an automated processing environment that can handle both volume spikes and future growth across all OTC asset classes.

Also, all credit default swap trades not cleared through a central counterparty will be reported to a central trade repository. More broadly, market participants agreed to strengthen industry governance structures and decision making processes to encompass a wide set of viewpoints.

In addition to the federal banking regulators, other regulators attending the meeting included the SEC, the CFTC, the European Central Bank, the German Federal Financial Supervisory Authority (BaFin), the UK Financial Services Authority, the Japan Financial Services Agency, and the PCAOB.

The meeting was also attended by the ISDA, SIFMA, the Counterparty Risk Management Policy Group III, and the Managed Funds Association.

Market participants attending the meeting included Bank of America, N.A., Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank AG, Goldman, Sachs & Co. HSBC Group, JPMorgan Chase, and Morgan Stanley.