The multitrillion-dollar market in privately arranged financial derivatives does not need government regulation and should not be subject to U.S. futures laws, top U.S. regulators said yesterday.
In a long-awaited report that eased market fears, the regulators recommended that Congress rewrite the Commodity Exchange Act (CEA), which governs U.S. futures trading, to provide clear legal certainty for widely used financial derivatives.
Derivatives are investments whose values are linked to underlying factors such as interest rates or currency exchange rates. The Bank for International Settlements has estimated that the total notional amount of outstanding over-the-counter derivatives contracts reached $80 trillion in 1998.
Market participants have worried for years that U.S. futures regulators could try to assert jurisdiction over the currently unregulated OTC market. That might have thrown the legal status of many contracts into question.
A special working group of U.S. regulators, including the Federal Reserve, Treasury Department, Securities and Exchange Commission and Commodity Futures Trading Commission (CFTC), studied the issue for more than a year. Congress will use the group's findings in a rewrite of U.S. futures laws due to be completed next year.
"This report goes a long way in helping resolve these difficult policy questions," Senate Agriculture Committee Chairman Richard G. Lugar (R-Ind.) said in a statement. "Our committee will strongly consider these recommendations as we begin the process of reauthorizing the Commodity Exchange Act."
The regulators decided that the sophisticated, usually institutional, investors who use financial derivatives to manage risk do not need the same sort of protections as small, retail investors in exchange-traded futures markets.
"With respect to OTC derivatives, the working group is unanimously recommending an exclusion from the CEA for bilateral transactions between sophisticated counterparties," the report said. Derivatives contracts based on physical commodities would not be covered by the proposed exclusion.
The CFTC, which oversees U.S. futures trading, last year caused a furor by suggesting it could claim authority over the OTC market, a move bitterly opposed by other financial regulators. Under a new chairman, however, the agency reversed course, allowing the working group to reach a consensus.
"We're lifting a cloud of legal uncertainty that has hung over this market for a number of years," Lee Sachs, assistant Treasury secretary for financial markets, told reporters.
In a joint statement, nine leading trade groups representing financial derivatives users and traders applauded the working group's recommendations.
"Many corporations, financial institutions and government entities in the United States and abroad rely on these contracts to manage risks, many of which could not be hedged or managed in an efficient way, if at all, without the use of these instruments," they said.
"The ability to pursue these activities with a clear legal framework in the United States is of vital economic interest."
The working group also recommended excluding electronic trading systems for OTC financial derivatives from U.S. futures laws, but left open the possibility that these could come under formal regulation at some time in the future. "If they become significant to the markets for OTC derivatives and if they take on a price-discovery function, it may be necessary," Sachs said.
The group urged the removal of legal barriers to the establishment of clearinghouses for OTC derivatives, as long as such systems are overseen by either the CFTC or another U.S. or recognized foreign regulator. Centralized clearing is seen as one way to mitigate the risks associated with the market.
The regulators also backed a CFTC initiative to deregulate financial futures trading to allow traditional U.S. exchanges to better compete with the OTC market, which the exchanges have long complained has been eating into their business.
In reaction, the Chicago Board of Trade, Chicago Mercantile Exchange and New York Mercantile Exchange said in a joint statement any regulatory reforms should be fair and evenhanded to both the exchange-traded and OTC markets.
"While the working group recognizes the regulatory disparities and blurred product distinctions that handcuff U.S. exchanges in today's competitive global market, the report does almost nothing to address those issues," the statement said. "This omission is a serious flaw."