I. Exchange of Information
II. Netting Arrangements
III. Capital Standards
IV. Management Controls
V. Customer Protection
VI. Multilateral Credit Risk Management Arrangements
VII. Accounting and Disclosure
The United States Securities and Exchange Commission ("SEC"), the Commodity Futures Trading Commission ("CFTC"), and the Securities and Investments Board ("SIB") have held discussions regarding securities and futures regulatory and enforcement matters for many years. In the context of such discussions, the SEC, CFTC and SIB ("Authorities") have discussed their respective approaches to the regulation of over-the-counter ("OTC") derivatives. They have noted not only the volume of transactions in OTC derivatives in their respective markets, but also the extent to which such transactions involve either cross-border business between their markets or activity in the jurisdiction of one Authority by a firm doing a securities or futures business which is (or whose parent or related entity is) based in the jurisdiction of another Authority.
The Authorities recognize that, while OTC derivatives transactions play a valuable role in the marketplace by, among other things, helping users to manage risk, OTC derivatives also involve risks for market intermediaries, end-users, and the marketplace. Accordingly, the Authorities have sought to identify ways in which they can cooperate in their respective regulatory approaches to OTC derivatives business. They have agreed on a coordinated approach, including an agenda for action, as set out below.
The Authorities also are agreed on the importance of cooperation in this area between regulatory authorities in different jurisdictions and of different financial institutions. Accordingly, they will work actively with other national and sectoral regulators to promote wider regulatory cooperation, while continuing individual efforts. In this context, the Authorities believe the work in progress in the International Organization of Securities Commissions regarding the regulation of OTC derivatives is valuable, and intend to continue working within that framework.
The Authorities recognize that a critical factor in a regulatory framework for addressing risk in international financial markets is the appropriate exchange of financial and operational information between regulators on a cross-border basis. The Authorities have agreed to enhance existing arrangements for the exchange of such information. In particular, the Authorities intend to exchange financial and operational information regarding major securities and futures firms with regard to whom SIB and either the SEC or the CFTC, as appropriate, have regulatory responsibilities and who conduct securities of futures business within their jurisdictions upon: (1) the triggering of a specifically defined early warning event that indicates to one of the Authorities that such securities or futures firm which it regulates may be experiencing significant financial or operational difficulties;1 or (2) a request of one of the Authorities based upon reasonable grounds for concern that the financial or operational condition of a securities or futures firm may be materially affected by a related entity.
Information provided will be, to the extent available, (1) the most recent financial and operational condition of the securities or futures firm, including the entity's net capital requirement, total net capital, and excess net capital; (2) upon request, the most recent financial and operational report filed by the securities or futures firm with the appropriate Authority (or their respective self-regulatory organizations); and (3) such other information as the Authorities deem appropriate.
To the extent that an Authority needs such information which is not in the possession of another Authority, the other Authority will use its best efforts to obtain that information from the appropriate source.
The Authorities will keep confidential, to the extent permitted by law, any information exchange between them, provided that such information may be disclosed in accordance with applicable law in order to carry out regulatory and enforcement objectives and responsibilities. In the event the recipient determines to act on information received, it will consult, to the maximum extent practicable, with the party supplying the information.
Appropriate netting arrangements that are legally enforceable in a bankruptcy proceeding are a critical component of risk management by enabling financial market participants to control and manage their credit exposure to counterparties. The Authorities will promote the use by securities or futures firms of appropriately designed netting arrangements which the Authorities are satisfied are legally enforceable. Accordingly, the Authorities agree that applicable capital standards should reflect, to the extent appropriate, the risk-reducing characteristics of legally enforceable netting arrangements. The Authorities will promote efforts to achieve mutually acceptable recognition of netting by financial regulators. The Authorities also will advocate, as appropriate, amendments to domestic (and, in the case of SIB, EC) insolvency and other relevant legislation.
The Authorities recognize that regulatory capital is a critical element in the prudential regulation of securities or futures firms and helps to address concerns regarding excessive leverage within such firms. Regulatory capital charges should address in particular, market and counterparty risks, and the risks involving concentrated exposures. In this context, the Authorities believe that regulatory capital standards should encourage incentives for good risk management, for example, by reflecting the risk-reducing characteristics of legally enforceable netting arrangements and of appropriate risk management techniques which satisfy standards set by the regulators. The Authorities also recognize that prudential supervision of the regulated activity must address in an appropriate way the risks to the regulated entity posed by related entities, for example by the reporting of information on material related entities by the regulated entity.
The Authorities have been engaged in work to review and (in the case of SIB, in order to implement the EC Capital Adequacy Directive) to modify, as appropriate, their capital standards. The Authorities will work to promote the establishment of prudent risk-based capital charges for securities and futures firms, taking into account prudential policies on customer funds. The Authorities also recognize that it is important, for prudential reasons, for securities and futures firms using proprietary models to incorporate and to undertake stress simulations approximating severe market movements.
Effective management controls are critical for a securities and futures firm because they provide the firm with the ability to monitor and control activities and risk. This is particularly important in the field of OTC derivatives because of the complexity, and rate of change, of the OTC products being developed. Accordingly, the Authorities will work together and with appropriate industry groups and participants to promote the development of sound management controls for the risk management of OTC derivative products by securities and futures firms.
The Authorities believe that management controls should enable securities and futures firms to monitor adequately their OTC derivatives activities and the risks arising therefrom (including their cash market relationships). In particular, controls normally should embrace, but not be limited to, the following concepts:
1. Policies about derivatives activities (addressing, inter alia, position limits, aggregated credit risk, and capital at risk) should be promulgated by the board of directors or equivalent body and should be reviewed as business market circumstances change.
2. Execution of these policies should be supported by valuation procedures and techniques (including mark-to-market mechanisms), risk management and information systems designed to ensure the adequacy of both management information and external reporting.
3. Responsibility for implementing the policies promulgated by the board of directors or equivalent body, without prejudice to its own responsibility, should be clearly delineated and the board of directors or equivalent body should define appropriate levels of any delegated authority for those responsible for implementing board or other equivalent body policies for supervising OTC derivatives activities.
4. Information systems should be designed to achieve full compliance with the policies and principles promulgated by the board of directors or other equivalent body and assist in the active management of derivatives activities. These systems should provide an adequate flow of relevant information about the derivatives activities not only of the firm but also of its related entities on a world-wide basis.
5. Appropriate expertise should be maintained at all levels of a firm.
6. Internal controls should include units dedicated to the evaluation of credit risk, market risk, and legal risk. These units should be independent of trading personnel and report directly to senior management.
7. Appropriate use should be made of risk reduction techniques, such as master agreements and credit enhancements, including collateralization.
The Authorities also will discuss with industry groups and participants how industry best practice can most effectively be disseminated, and standards of management control developed, on a continuing basis; how regulatory authorities can best encourage this process; and the means by which the regulators can best be given grounds for confidence that firms active in OTC derivatives business are aware of, and applying, adequate standards of risk management relative to their individual circumstances.
Having regard to the complexity and lack of transparency characteristic of many OTC derivatives products, the Authorities, as necessary, will encourage the development of a regulatory framework that addresses the particular suitability, know your customer or access issues arising in OTC derivative transactions. The Authorities will request relevant self-regulatory organizations to review, and where necessary, amend their customer transaction requirements to reflect the nature of the OTC derivatives business. One approach would be for the self-regulatory organizations to work with market participants to consider what steps are necessary to ensure, in appropriate cases, that members making a recommendation for an OTC derivatives transaction to a customer other than a dealer in OTC derivatives possess sufficient information about the customer and its resources to assess the appropriateness of the transaction for the customer, including information about whether the customer, by reason of its business or experience, has the capability to understand the risks relating to the transaction. The Authorities also will take appropriate steps to encourage regulated end-users to establish and maintain management controls that address the risks posed by their transactions in derivative products.
In exchange-traded derivative markets, clearinghouses play an important role in reducing credit risk by becoming the counterparty to every trade and by taking on responsibility for the calling and receiving of margin and collateral. In these ways they promote confidence in the markets, and thereby increase liquidity. They also can provide other useful services to their markets and members which facilitate matching, registration and the allocation, offset, record of execution and designation of trades. Such services and related systems encourage the maintenance of efficient back office procedures, assist in the production and dissemination of market data, and contribute to market transparency.
In the case of the OTC derivatives market, which has been characterized by customized products lacking the price transparency and liquidity of exchange-traded products, credit risk management so far has been addressed primarily at the level of individual firm and by the development of enforceable bilateral netting arrangements. The Authorities believe that similar benefits to those derived from a clearing house for exchange-traded products also could be of value to persons engaging in OTC derivatives transactions given appropriate design and oversight.
Having regard to the interest that has been expressed in the development of multilateral approaches to a reduction in credit risk, the Authorities consider it timely to work with other industry groups and participants to consider the regulatory framework which should apply to clearinghouses (or to other multilateral arrangements) for OTC derivative credit risk management, whether on a domestic or international basis.
The Authorities attach great importance to the development of accounting recognition, measurement, and disclosure standards by national and international accounting standard setting bodies that will result in financial statements of securities and futures firms and end-users active in the OTC and exchange-traded derivatives markets that achieve greater market transparency and adequate information for users of financial statements. Accordingly, the Authorities will join together in urging accounting standard setters to develop such standards.
1 In the U.S., this would be when (1) a securities firm provides notice to its designated U.S. self regulatory organization ("U.S. SRO") and the SEC as required by Rule 17a-11 under the Securities Exchange Act of 1934 that the securities firm's (a) minimum net capital falls below the minimum required by the SEC's net capital rule, (b) books and records are not current, or (c) accounting system, internal accounting controls or procedures for safeguarding securities are materially inadequate; or (2) a notification is filed by a U.S. SRO or the SEC with the Securities Investor Protection Corporation ("SIPC") pursuant to Section 5(a)(1) of the Securities Investor Protection Act of 1970 that a SIPC member securities firm is in or approaching financial difficulty. In addition, this also would be when a securities firm notifies its regulator that it has made, or is about to make, a material default, whether OTC or on an exchange.
This would also be in the event that (1) a firm doing a futures business provides notice to its U.S. SRO and the CFTC as required pursuant to Rule 1.12 under the Commodity Exchange Act ("CEA") that (a) the futures firm's adjusted net capital has fallen below the minimum required by an applicable net capital rule, (b) books and records are not current, or (c) the accounting system, internal accounting controls, procedures for safeguarding customer and firm assets or certain other practices and procedures specified in Rule 1.16(d)(1) under the CEA, are materially inadequate; (2) a notification is filed with the CFTC under Rule 190.6 of a bankruptcy filing; or (3) in the event a futures firm otherwise notifies its regulator of information affecting its continuing financial or operational viability.
In the U.K. this would be when a regulator has reason to believe a securities or futures firm for which it is the responsible authority (1) is or will be in breach of its financial resources requirements; (2) will, or expects to, be unable to submit a financial reporting statement when due; (3) has made, or is about to make, a material default, whether OTC or on an exchange; or (4) is, or expects to be, unable to maintain adequate accounting records or adequate internal controls and systems.