	Background

The financial crisis implicated the unregulated over-the-counter (OTC) derivatives market as a major source of systemic risk. In the wake of the crisis, lawmakers sought to introduce regulatory controls over this market, which many viewed as opaque and unregulated. This report examines how conflicts of interest in derivatives clearinghouses may arise, and what impact such conflicts could have on derivatives reform. It analyzes the measures that the CFTC and SEC have proposed to address such conflicts, and whether such proposed measures effectively address the types of conflicts of interest that are of concern to some in the 112 th Congress. These rulemakings may interest the 112 th Congress as part of its oversight authority over the CFTC and SEC. The effect of the margin system is to eliminate the possibility that any market participant can build up an uncapitalized exposure (or paper loss) so large that default would cause the clearinghouse to fail. No futures clearinghouse in the United States has ever failed. Clearinghouses limit the size of a cleared position based on a firm's ability to post margin to cover its potential losses. Futures contracts are traded on exchanges regulated by the Commodity Futures Trading Commission (CFTC). Stock options are traded on exchanges regulated by the Securities and Exchange Commission (SEC). The Dodd-Frank Act seeks to make standardized clearing of all forms of derivatives the norm, especially in transactions where the counterparties are systemically important financial institutions. Difficulty in pricing swaps could be a source of systemic risk. The regulators must approve the swap for clearing . Conflicts of Interest in Clearing

As lawmakers focused on clearing, concerns arose as to whether the small number of large swaps dealers in existence might influence clearinghouses or trading platforms in ways that could undermine the potential efficacy of clearing in mitigating systemic risk. 4173 , which would have restricted ownership interest and governance of the new derivatives clearinghouses by certain large financial institutions and major swap participants. The Senate, however, did not take the approach of the Lynch amendment in its version of H.R. In the final Dodd-Frank Act, Sections 726 and 765 mandate that the CFTC and SEC, respectively, must adopt rules to mitigate conflicts of interest; but leave it to the agencies themselves to decide whether those rules should include strict numerical limits on ownership or control. In the CFTC's proposed rules to mitigate conflicts of interest, published on October 18, 2010, and on January 6, 2011, the CFTC did choose to propose strict ownership limits, along the lines of the Lynch amendment. The SEC's proposed rules also adopt such limits. They also argue that limiting the ownership of large banks who are the major swap dealers would also limit the crucial expertise on swaps that DCOs need in order to accurately assess the riskiness of various derivatives, and to decide whether to clear them, and if so, how to set margin requirements accurately. We saw the same large banks fail to require sufficient collateral from AIG in the lead-up to the financial crisis, they explain; and as a result of the "undercapitalization" of these banks, billions of dollars were needed from Treasury, the Federal Reserve, and the FDIC to prevent widespread default. Appendix. For the OTC market as a whole, the interest rate swaps market is by far the largest OTC product traded, representing about 93% of the notional amount of OTC derivatives.
The financial crisis implicated the over-the-counter (OTC) derivatives market as a source of systemic risk. In the wake of the crisis, lawmakers sought to reduce systemic risk to the financial system by regulating this market. One of the reforms that Congress introduced in the Dodd-Frank Act (P.L. 111-203) was mandatory clearing of OTC derivatives through clearinghouses, in an effort to remake the OTC market more in the image of the regulated futures exchanges. Clearinghouses require traders to put down cash or liquid assets, called margin, to cover potential losses and prevent any firm from building up a large uncapitalized exposure, as happened in the case of the American International Group (AIG). Clearinghouses thus limit the size of a cleared position based on a firm's ability to post margin to cover its potential losses.
As lawmakers focused on clearing requirements to reduce systemic risk, concerns also arose as to whether the small number of large swaps dealers in existence—mostly the largest banks—might influence clearinghouses or trading platforms in ways that could undermine the efficacy of the approach. Concerns about conflicts of interest in clearing center around whether, if large swap dealers dominate a clearinghouse, they might directly or indirectly restrict access to the clearinghouse; whether they might limit the scope of derivatives products eligible for clearing; or whether they might influence a clearinghouse to lower margin requirements.
Trading in OTC derivatives is in fact concentrated around a dozen or so major dealers. The Office of the Comptroller of the Currency (OCC) estimated that, as of the third quarter of 2010, five large commercial banks in the United States represented 96% of the banking industry's total notional amounts of all derivatives; and those five banks represented 81% of the industry's net credit exposure to derivatives. The first group of Troubled Asset Relief Program (TARP) recipients included nearly all the large derivatives dealers. As a result of the high degree of market concentration, the failure of a large swaps dealer still has the potential to result in the nullification of tens of billions of dollars worth of contracts, which could pose a systemic threat.
A 2009-proposed amendment proposed to H.R. 4173, which passed the House, would have limited ownership interest and governance of the new derivatives clearinghouses by certain large financial institutions and major swap participants. Sections 726 and 765 in the final version of the Dodd-Frank Act mandate that the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC), respectively, must adopt rules to mitigate conflicts of interest. However, it allowed the agencies to decide whether those rules include strict numerical limits on ownership or control. In the CFTC's proposed rules to mitigate conflicts of interest, published on October 18, 2010, and on January 6, 2011, the CFTC did choose to adopt strict ownership limits, along the lines of the Lynch amendment. The SEC's proposed rule, published on October 13, 2010, does the same.
This report examines how conflicts of interest may arise and analyzes the measures that the CFTC and SEC proposed to address them. It discusses what effect, if any, ownership and control limits may have on derivatives clearing; and whether such limits effectively address the types of conflicts of interest that are of concern to some in the 112th Congress. These rulemakings may interest the 112th Congress as part of its oversight authority for the CFTC and SEC. Trends in clearing and trading derivatives, and the ownership of swap clearinghouses, are discussed in the Appendix.