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Derivatives, or financial instruments whose value is based on an
underlying asset, played a key role in the financial crisis of
2008-2009. Congress directly addressed the governance of the
derivatives markets through the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank; P.L. 111-203; July 21, 2010).
This Act, in Title VII, sought to bring the largely unregulated
over-the-counter (OTC) derivatives markets under greater regulatory
control and scrutiny. Pillars of this approach included mandating
that certain OTC derivatives be subject to central clearing, such
as through a clearinghouse, which involves posting margin to cover
potential losses; greater transparency through trading on exchanges
or exchange-like facilities; and reporting trades to a repository,
among other reforms. In the debates over Dodd-Frank and in
subsequent years, many in Congress have raised the following
important questions: If the United States takes stronger regulatory
action than other countries, will business in these OTC derivatives
markets shift overseas? Since OTC derivatives markets are global in
nature, could derivatives trading across borders, or business for
U.S. financial firms that engage in these trades, be disrupted if
other countries do not adopt similar regulatory frameworks? The
first step in addressing these congressional concerns is to examine
the degree to which other major countries have adopted similar
legislation and regulation as the United States, particularly in
light of commitments from the Group of Twenty nations (G-20) to
adopt certain derivatives reforms. Following the financial crisis,
G-20 leaders (generally political heads of state) established a
reform agenda and priorities within that agenda for regulating and
overseeing OTC derivatives. The G-20 as an organization has no
enforcement capabilities, but relies on the members themselves to
implement reforms. According to recent surveys, most members are
making progress in meeting the self-imposed goal of implementing
major reforms in derivatives markets. Only the United States
appears to have met all the reforms endorsed by the G-20 members
within the desired timeframe of year-end 2012. The European Union
(EU), Japan, Hong Kong, and the United States have each taken
significant steps towards implementing legislation requiring
central clearing. However, in most of these jurisdictions
legislation has not yet been followed up with technical
implementing regulations for the requirements to become effective,
according to the Financial Stability Board (FSB), which conducts
the surveys. Most authorities surveyed estimated that a significant
proportion of interest rate derivatives would be centrally cleared
by year-end 2012, but they were less confident of progress for
other asset classes. The EU appeared to be making progress in its
G-20 derivatives regulatory commitments, particularly in central
clearing and trade repository-reporting requirements, but at a
slower pace than the United States, according to the FSB. This may
be due in part to the need for legislation to be passed by
individual national legislatures even when agreed broadly by the
EU. As of October 2012, however, only the United States had adopted
legislation requiring standardized derivatives to be traded on
exchanges and electronic platforms. This report examines the G-20
recommendations for reforming OTC derivatives markets and presents
the result of self-assessment surveys measuring the performance of
G-20 members and some FSB members to date in meeting their
commitments. The Appendix to the report presents more detailed
information on the status of individual jurisdictions in
implementing the G-20- endorsed reforms. The Glossary defines key
international bodies and related financial terms and concepts.
The financial crisis implicated the over-the-counter (OTC)
derivatives market as a major source of systemic risk. A number of
firms used derivatives to construct highly leveraged speculative
positions, which generated enormous losses that threatened to
bankrupt not only the firms themselves but also their creditors and
trading partners. Hundreds of billions of dollars in government
credit were needed to prevent such losses from cascading throughout
the system. AIG was the best-known example, but by no means the
only one. Equally troublesome was the fact that the OTC market
depended on the financial stability of a dozen or so major dealers.
Failure of a dealer would have resulted in the nullification of
trillions of dollars' worth of contracts and would have exposed
derivatives counterparties to sudden risk and loss, exacerbating
the cycle of deleveraging and withholding of credit that
characterized the crisis. During the crisis, all the major dealers
came under stress, and even though derivatives dealing was not
generally the direct source of financial weakness, a collapse of
the $600 trillion OTC derivatives market was imminent absent
federal intervention. The first group of Troubled Asset Relief
Program (TARP) recipients included nearly all the large derivatives
dealers. The Dodd-Frank Act (P.L. 111-203) sought to remake the OTC
market in the image of the regulated futures exchanges. Crucial
reforms include a requirement that swap contracts be cleared
through a central counterparty regulated by one or more federal
agencies. Clearinghouses require traders to put down cash (called
initial margin) at the time they open a contract to cover potential
losses, and require subsequent deposits (called maintenance margin)
to cover actual losses to the position. The intended effect of
margin requirements is to eliminate the possibility that any firm
can build up an uncapitalized exposure so large that default would
have systemic consequences (again, the AIG situation). The size of
a cleared position is limited by the firm's ability to post capital
to cover its losses. That capital protects its trading partners and
the system as a whole. Swap dealers and major swap
participants-firms with substantial derivatives positions-will be
subject to margin and capital requirements above and beyond what
the clearinghouses mandate. Swaps that are cleared will also be
subject to trading on an exchange, or an exchange-like "swap
execution facility," regulated by either the Commodity Futures
Trading Commission (CFTC) or the Securities and Exchange Commission
(SEC), in the case of security-based swaps. All trades will be
reported to data repositories, so that regulators will have
complete information about all derivatives positions. Data on swap
prices and trading volumes will be made public. The Dodd-Frank Act
provides exceptions to the clearing and trading requirements for
commercial end-users, or firms that use derivatives to hedge the
risks of their nonfinancial business operations. Regulators may
also provide exemptions for smaller financial institutions. Even
trades that are exempt from the clearing and exchange-trading
requirements, however, will have to be reported to data
repositories or directly to regulators.
On May 10, 2012, JP Morgan disclosed that it had lost more than $2
billion by trading financial derivatives. Jamie Dimon, CEO and
chairman of JP Morgan, reported that the bank's Chief Investment
Office (CIO) executed the trades to hedge the firm's overall credit
exposure as part of the bank's asset liability management program
(ALM). The CIO operated within the depository subsidiary of JP
Morgan, although its offices were in London. The funding for the
trades came from what JP Morgan characterized as excess deposits,
which are the difference between deposits held by the bank and its
commercial loans. The trading losses resulted from an attempt to
unwind a previous hedge investment, although the precise details
remain unconfirmed. The losses occurred in part because the CIO
chose to place a new counter-hedge position, rather than simply
unwind the original position. In 2007 and 2008, JP Morgan had
bought an index tied to credit default swaps on a broad index of
high-grade corporate bonds. In general, this index would tend to
protect JP Morgan if general economic conditions worsened (or
systemic risk increased) because the perceived health of highgrade
firms would tend to deteriorate with the economy. In 2011, the CIO
decided to change the firm's position by implementing a new counter
trade. Because this new trade was not identical to the earlier
trades, it introduced basis risk and market risk, among other
potential problems. It is this second "hedge on a hedge" that is
responsible for the losses in 2012. Several financial regulators
are responsible for overseeing elements of the JP Morgan trading
losses. The Office of the Comptroller of the Currency (OCC) is the
primary prudential regulator of federally chartered depository
banks and their ALM activities, including the CIO of JP Morgan,
even though it is located in London. The Federal Reserve is the
prudential regulator of JP Morgan's holding company, although it
would tend to defer to the primary prudential regulators of the
firm's subsidiaries for significant regulation of those entities.
The Federal Reserve also regulates systemic risk aspects of large
financial firms such as JP Morgan. The CIO must comply with Federal
Deposit Insurance Corporation (FDIC) regulations because it is part
of the insured depository. The Securities and Exchange Commission
(SEC) oversees JP Morgan's required disclosures to the firm's
stockholders regarding material risks and losses such as the
trades. The Commodity Futures Trading Commission (CFTC) regulates
trading in swaps and financial derivatives. The heads of these
agencies coordinate through the Financial Stability Oversight
Council (FSOC), which is chaired by the Secretary of Treasury. The
trading losses may have implications for a number of financial
regulatory issues. For example, should the exemption to the Volcker
Rule for hedging be interpreted broadly enough to encompass general
portfolio hedges like the JP Morgan trades, or should hedging be
limited to more specific risks? Are current regulations of large
financial firms the appropriate balance to address perceptions that
some firms are too-big-to-fail? The trading losses raise concerns
about the calculation and reporting of risk by large financial
firms. JP Morgan changed its value at risk (VaR) model during the
time of the trading losses. Some are concerned that VaR models may
not adequately address potential risks. Some are concerned that the
change in reporting of the VaR at JP Morgan's CIO may not have
provided adequate disclosures of the potential risks that JP Morgan
faced. Such disclosures are governed by securities laws.
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