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Treasury's Regulatory Revamp Plan Includes OTC Settlement Oversight
Calling it systemically important, the Treasury Department has proposed that the payment and settlement infrastructure of the over-the-counter derivatives markets be placed under the oversight of the Federal Reserve.
The recommendation, part of the much-debated plan to overhaul the U.S. regulatory structure, was cited by Treasury Secretary Henry Paulson last week when he announced the release of the blueprint that had been in the works for about a year.
Such a step would at a minimum require additional data retrieval capabilities from industry infrastructures such as the Depository Trust & Clearing Corp. (DTCC), which provides a centralized platform for electronically settling fixed-income trades, including the OTC credit derivatives that dealers choose to channel through its Deriv-Serv system.
On March 13, Paulson, urging the industry to take up recommendations from the President's Working Group on Financial Markets to improve the processing of OTC derivatives, suggested an "industry cooperative," pointing to DTCC's role in other bond markets. But Treasury's blueprint calls for regulatory supervision of any system deemed "systemically important."
Deriv-Serv is not regulated, and DTCC's other processing arms--the Depository Trust Co., National Securities Clearing Corp. and Fixed-Income Clearing Corp.--while registered with the Securities and Exchange Commission, do not face the same scrutiny as market participants such as broker-dealers and exchanges.
If the proposal to have the Fed monitor risk in the payments and settlements system comes to fruition, industry-owned DTCC, as the U.S. capital markets' central processing and settlement hub, will need to be included, at least in some respect. Risk monitoring by the Fed would also require dealers to report much more data on bond and credit derivatives trades and positions than they currently do.
To receive such data, the Fed would need to establish a central collection point--either at DTCC or a similar entity--where the data resides or can be easily retrieved. Alternatively, the Fed could have the dealers report positions individually; dealers currently report to the New York Fed, in aggregate, trade failures in vanilla bonds often used in repurchase agreements. The Fed could also collect the data from interdealer platforms and multidealer systems that offer credit derivatives.
Root-Level Threat
Said Paulson last week, "Consider that our current regulatory regime is almost solely focused above ground at the tree level," when "the real threat to market stability is below ground, at the root level where the health of financial firms is intertwined." One root-level system that would require attention from the blueprint's proposed market stability regulator is "the interconnected OTC derivatives markets with their lack of a cohesive design for clearing, settlement and novation protocols."
Treasury's plan states that, in the U.S., "major payment and settlement systems are generally not subject to any uniform, specifically designed and overarching regulatory system. Moreover, there is no defined category within financial regulation focused on payment and settlement systems. As a result, regulation ... is idiosyncratic, reflecting choices made by payment and settlement systems based on options available at some previous time."
The blueprint suggests that "a federal charter for systemically important payment and settlement systems should be created and should incorporate federal preemption." The Fed would be assigned "primary oversight responsibilities" and the ability to designate systems as systemically important, as well as "a full range of authority to establish regulatory standards."
The Fed "could be authorized to require that financial institutions limit or more carefully monitor risk exposures to certain asset classes or counterparties," says the document. "Such a corrective action could require that exposures to certain asset classes ... be constrained by either limiting future increases in exposure or limiting exposure to a certain percentage of capital."
The agency could also "require that certain actions be taken to address liquidity and funding issues. Such a corrective action could require that financial institutions maintain or bolster their liquidity positions to ensure that short-term funding needs can be met. The potential scope of these actions would be broad, and could involve issues ranging from exposure to credit default swaps and the proper functioning of the repurchase market."
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