Curtin on the Over-the-Counter Derivatives Markets Act of 2009

Curtin on the Over-the-Counter Derivatives Markets Act of 2009

The Obama administration presented a 1st phase regulatory reform initiative: the Over-the-Counter (OTC) Derivatives Markets Act of 2009. If enacted, this new law will significantly impact the regulatory landscape affecting established dealers, hedge funds, and countless other market participants. It would repeal Section 206B of the Gramm-Leach-Bliley Act and would make explicit that security-based swaps are securities subject to the Securities and Exchange Acts.
 
In this commentary, Edmond J. Curtin discusses how the proposed Over-the-Counter Derivatives Markets Act of 2009 would regulate “swaps.”  In addition to providing a summary and an analysis of the draft law, specifically with reference to the duties and liabilities imposed on dealers and end-users in OTC derivatives, this commentary also includes a statement of fourteen propositions referred to herein as "Rules." The author further explains that the regulation of the OTC derivatives markets under the Draft Law is premised on certain legal categories.
 
Mr. Curtin writes:
 
     It is said that the market in over-the-counter (OTC) derivatives is unregulated. By this, I think, one would mean that the broad privilege that the law allows to persons to enter into contractual relationships remains (largely) unfettered even if that contractual relationship may be labelled an "OTC derivative." Although regulation itself may take different forms, it may be said (at a somewhat abstract level) that regulation consists of two things. Firstly, the creation of a new legal category (being the thing or the activity being regulated). Secondly, the making conditional of the lawful privilege to conduct that activity or to transact in or with respect to that thing. Thus, regulation constitutes a derogation from a general pre-existing privilege (or freedom) to constitute legal relationships consensually.
 
 
     More broadly (and politically) one might see the Draft Law as another incident in the ongoing conflict relating to the position of privately-negotiated OTC derivatives within the regulatory regimes for financial instruments in the United States. Those regimes are, crudely, premised on the legal categories for transactions in "securities" and transactions in "commodities for future delivery," with the CFTC and the SEC having respective authority. Neither of those legal categories contains OTC derivatives but, insofar as an OTC derivative may constitute some or all of the attributes of those legal categories, OTC derivatives may be said to contain them. This led to conflict and uncertainty, in particular, as to how the frontiers of these legal categories might be properly defined. It was perhaps thought that the Commodity Futures Modernization Act of 2000 had brought this conflict to an end in defining more clearly the frontiers between OTC derivatives and these two other legal categories.
 
 
     Under the Draft Law, it shall be unlawful to enter into a swap that is standardized unless two conditions are satisfied. The first condition is that the swap is cleared by a registered central counterparty--"derivatives clearing organization" or "clearing agency" (CCP). The second condition is that the rules of this registered CCP prescribe that all swaps with the same terms and conditions are fungible and may be offset with each other.
 
 
     End-users of OTC derivatives are often, but not inevitably, regulated entities because of the business that they otherwise conduct. However, it is an interesting innovation in the Draft Law that end-users of "swaps" would become subject to regulation (alongside dealers in swaps) thereunder as such once a significant threshold is passed. The legal characteristic "substantial net position" is certainly one that will require further elucidation by the regulators. However, the Draft Law proposes that one may exclude for those purposes swaps constituted to create or maintain an effective hedge under the applicable GAAP accounting rules.
 
 
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