Financial Services Regulatory Reform: Credit Default Swaps and the OTC Derivatives Market: Proposed Legislation & President’s Working Group Initiatives, including SEC Issuance of Temporary Exemptions for Central Counterparties

December 23, 2008

In connection with regulatory reform legislation anticipated to be introduced in the 111th Congress, consideration will be given to enacting proposals to further legislate the swaps market and, in particular, credit default swaps ("CDS") and the over-the-counter ("OTC") derivatives market.

In addition, regardless of the outcome of such reform, the President’s Working Group on Financial Markets (the "PWG") is currently initiating structural and regulatory changes to the OTC derivatives market.

This update focuses on developments in these areas, including describing recent Congressional hearings and legislative proposals.  It also summarizes current and anticipated actions of the PWG.

Legislative Hearings and Proposals

One example of developments in this area are the extensive hearings [1] that the House Committee on Agriculture held during the fourth quarter of 2008 to review the role of credit derivatives in the U.S. economy.  The Senate Agricultural Committee also held a hearing in October 2008 [2].

As a result of the Senate hearing, in November 2008, Senate Agricultural Committee Chairman Tom Harkin (D-Iowa) introduced the Derivatives Trading Integrity Act of 2008 [3] (the "Act").  The Act essentially amends the Commodity Exchange Act ("CEA") to require that derivatives contracts, including CDS, be regulated as futures contracts and be executed on a regulated exchange instead of in the OTC market.

As a result, the Commodities Futures Trading Commission ("CFTC") would have regulatory authority over such contracts.  This proposed legislation joins other legislative proposals from earlier in the year to regulate derivatives and the OTC market.

The Future of the CFTC and the OTC Derivatives Market 

Given that President-elect Barack Obama has selected Mary Schapiro, formerly chairman of the CFTC, to chair the Securities and Exchange Commission ("SEC"), this potentially facilitates the merger of the SEC and CFTC in connection with regulatory reform legislation.

At the same time, potential opposition to such a merger could arise from the House and Senate Agricultural Committees as the loss of the CFTC as an agency could mean that the Agricultural Committees could correspondingly lose jurisdiction over the derivatives market, including CDS.  This could prove problematic to an initiative to consolidate these agencies.

President’s Working Group on Financial Markets

Separately, the PWG has announced "a series of initiatives [4] to strengthen oversight and the infrastructure" of the OTC derivatives market.   A key component of the PWG’s initiatives is addressing any regulatory impediments to the development of CDS central counterparties ("CCPs"), which are viewed as beneficial to reducing the systemic risks associated with counterparty credit exposures in the CDS market.

One challenge has been that each of the Board of Governors of the Federal Reserve System ("Federal Reserve"), the SEC and the CFTC has prescribed regulatory responsibilities with respect to CDS CCPs.  To address this issue, on November 14, 2008, the three regulators entered into a Memorandum of Understanding [5] ("MOU") regarding CDS central counterparties.   The MOU is intended to facilitate the regulatory approval process for CCPs and to promote more consistent regulatory oversight among the three regulators by establishing a framework for consultation and information sharing on issues related to CDS CCPs.

Among other things, the regulatory framework that is likely to develop to facilitate the launch of CCPs is expected to include:

  • risk management protocols requiring accurate and timely information of participants’ positions, exposures, and collateral requirements and needs;
  • a CCP guaranty fund;
  • additional record keeping requirements, including transaction reporting requirements to facilitate creation of audit trails;
  • increased transparency through the CCP’s collection and reporting of pricing information, trading volumes and open interest, see Testimony of Dr. Erik R. Sirri [6] Concerning Credit Default Swaps (Nov. 20, 2008);  and
  • information sharing among the Federal Reserve, SEC and CFTC concerning CCPs’ financial condition, risk management systems, internal controls, liquidity and financial resources, operations, and governance as well as results and reports of examinations of CCPs.

Today, the SEC approved [7], on a seriatim basis, temporary and conditional exemptions allowing LCH.Clearnet Ltd. to operate as a central counterparty to clear European index CDS, which will be negotiated and agreed away from Liffe.  As a result, Liffe, the global derivatives business of NYSE Euronext, becomes the first exchange to offer clearing of CDS contracts.  The SEC stated that it developed the temporary exemptions in "close consultation with the [Federal Reserve, the Federal Bank of New York, the CFTC, and the U.K. Financial Services Authority]" and it is expected that the exemptions will further PWG’s Policy Objectives For The OTC Derivatives Market [8].

The exemptions are considered necessary to address the loss of the swap exclusion from the federal securities laws provided by the Commodities Futures Modernization Act of 2000 ("CFMA") due to the standardization of contracts in order to facilitate centralized clearing and exchange trading.  The SEC’s order is not yet publicly available, but will be published in the Federal Register for public comment.  During the comment period, the SEC will examine the operations of CCPs to determine if registration, e.g., as clearing agencies, is required and whether the exemptions should be made permanent.

Three other proposals to operate CDS CCPs are currently pending with the regulators, including an initiative by the IntercontinentalExchange, Inc. ("ICE") and The Clearing Corporation, together with nine global investment banks,, which recently received approval [9] from the New York State Banking Board to create a New York-charted trust company, ICE US Trust LLC, to serve as a central clearing facility for CDSs.    Federal approval for ICE to operate a CCP is still pending with the Federal Reserve.

Among the other issues still to be addressed are, the extent to which cross margining will be permitted, if any, whether cross-border CCPs will develop, and linkages and systemic risk monitoring across CCPs.











Gibson, Dunn & Crutcher LLP 

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have the issues discussed above.  Please contact

Christopher J. Bellini(202- 887-3693, [email protected]) or 
K. Susan Grafton (202-887-3554, [email protected]

in the firm’s Washington, D.C. office or the Gibson Dunn attorney with whom you work.

© 2008 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.