OTC Derivatives:

Additional Oversight Could Reduce Costly Sales Practice Disputes

GGD-98-5: Published: Oct 2, 1997. Publicly Released: Oct 9, 1997.

Contact:

Thomas J. McCool
(202) 512-8678
contact@gao.gov

 

Office of Public Affairs
(202) 512-4800
youngc1@gao.gov

Pursuant to a congressional request, GAO reviewed the sales practices for over-the-counter (OTC) derivatives, mortgage-backed securities (MBS), and structured notes, focusing on the: (1) federal sales practice requirements applicable to these products and the dealers marketing them; (2) extent of end-user satisfaction with sales practice, product use, and related disputes and the costs of these disputes; (3) views of end-users and dealers on the nature of their relationship and responsibilities; (4) actions dealers and end-users have taken to reduce the potential for sales practice disputes; and (5) actions regulators have taken to address sales practice issues.

GAO noted that: (1) the extent to which OTC derivatives are subject to federal sales practice requirements intended to protect end-users varies, depending, in part, on whether they are considered to be securities, futures, or neither; (2) when they are considered to be securities or futures, their sale is covered by the federal securities or commodities laws, and they are regulated by the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), respectively; (3) to the extent that these products are not securities or futures, end-users with sales practice disputes would need to seek redress against a dealer by asserting primarily state statutory or common law claims; (4) in contrast to most OTC derivatives, MBS and structured notes are typically securities and, thereby, subject to the federal securities laws, except when exempted from specific provisions; (5) the extent to which sales practice requirements apply to the dealers marketing OTC derivatives in the United States also varies, depending on whether the dealer offering them is regulated; (6) when OTC derivatives are marketed by banks, they are subject to supervisory guidance issued by federal bank regulators; (7) securities, futures, and insurance firms, unlike banks, typically market OTC derivatives that they consider to be neither securities nor futures from affiliates that are not subject to any direct federal financial regulatory oversight, although some individual transactions may be subject to such oversight; (8) although sales practice requirements vary by product and dealer, according to GAO's survey, most end-users were generally satisfied with the sales practices of the dealers with whom they entered transactions; (9) GAO's survey also found that relatively few organizations reported using OTC derivatives; (10) GAO's review of regulatory and public records, covering 1993 through 1996, indicated that cases involving actual or alleged deficiencies in dealer sales practices were limited in number; (11) however, the dealers and end-users involved in these cases often experienced significant costs; (12) although generally satisfied with dealer sales practices, end-users' views on the nature of counterparty relationships sometimes differed from those of dealers; (13) in addition, bank regulators have taken certain actions to address sales practice issues; and (14) although SEC and CFTC do not directly regulate the affiliates that securities and futures firms use to conduct their OTC derivatives activities, SEC and CFTC worked with the most active of these firms to produce one of two sets of voluntary guidance.

Status Legend:

More Info
  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: The Chairpersons, SEC and CFTC, should establish a mechanism for determining that participating firms are following the sales provisions of the Framework for Voluntary Oversight.

    Agency Affected: Commodity Futures Trading Commission

    Status: Closed - Implemented

    Comments: CFTC continues to be in dialogue with other regulators about the role that it plays regarding OTC derivatives, including regarding the applicability of any of its sales practice regulations. Since the report was issued, few additional disputes have arisen and the end-user community has not subsequently made calls for regulators to revise their approach to OTC derivative sales practice issues. However, Securities and Exchange Commission and CFTC officials have conducted discussions with dealer firms regarding their sales practices for OTC derivatives and intend to periodically address these issues with these firms in the future.

    Recommendation: The Chairman of the Federal Reserve Board should implement planned revisions to the Federal Reserve examination guidance, which are to more specifically address the need to assess the adequacy of banks' policies and controls related to disclosing risks, creating advisory relationships, and supervising marketing personnel.

    Agency Affected: Federal Reserve System: Board of Governors

    Status: Closed - Implemented

    Comments: In February 1998, the Federal Reserve issued the latest version of its "Trading and Capital Markets Activities Manual" that included additional detail. The new manual indicates that banks should have policies and controls to ensure that the counterparties they deal with adequately understand the risks of the transactions involved and that sales materials also accurately discuss such risks. It also indicates that banks should have policies that direct bank staff to avoid actions that create the appearance of advisory relationships with a counterparty where none is intended. The manual also discusses the need for banks to provide guidance and training to marketing personnel, have procedures and mechanisms to document analyses of transactions and disclosures to counterparties, and have internal controls to ensure ongoing adherence to disclosure and customer appropriateness policies and procedures. Examiners are directed to determine how compliance with sales practice policies are monitored by banks.

    Recommendation: The Secretary of the Treasury, as Chairman of the President's Working Group on Financial Markets, should lead the members of the Working Group in considering the extent to which it should assist end-users and dealers in reaching agreement on the nature of their relationship in transactions involving OTC derivatives.

    Agency Affected: Department of the Treasury

    Status: Closed - Not Implemented

    Comments: Although various regulatory or congressional actions are pending which may affect how dealers of OTC derivatives are regulated, these proposals do not generally change the nature of the sales practice responsibilities of these dealers. Since the time GAO made this recommendation, few additional disputes have arisen and the end-user community has not subsequently made calls for regulators to revise their approach to OTC derivative sales practice issues. The members of the President's Working Group on Financial Markets considered but chose not to take action regarding the status of dealer and end-user relationships.

    Recommendation: The Secretary of the Treasury, as Chairman of the President's Working Group on Financial Markets, should ensure that the members of the Working Group establish a mechanism for systematically monitoring developments in the OTC derivatives markets to assess whether developments warrant introducing specific federal sales practice requirements.

    Agency Affected: Department of the Treasury

    Status: Closed - Not Implemented

    Comments: According to Treasury Department officials that coordinate issues for the President's Working Group on Financial Markets, the majority of the Working Group members did not accept GAO's call for them to create a more formal mechanism for monitoring sales practice issues. Instead, they will address this issue on an as-needed basis.

    Recommendation: The Chairpersons, SEC and CFTC, should establish a mechanism for determining that participating firms are following the sales provisions of the Framework for Voluntary Oversight.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: Since the report was issued, few additional disputes have arisen and the end-user community has not subsequently made calls for regulators to revise their approach to OTC derivative sales practice issues. SEC has approved rules that will allow securities firms currently conducting OTC derivatives in unregulated affiliates to register with the agency. These firms' activities would thus be subject to a modified form of SEC regulation, including reporting and capital requirements, although any activities involving non-securities OTC derivatives would continue to remain outside of the sales practice portions of the securities regulations. However, SEC and Commodity Futures Trading Commission officials have conducted discussions with dealer firms regarding their sales practices for OTC derivatives and intend to periodically address these issues with these firms in the future.

    Mar 26, 2014

    Jan 13, 2014

    Dec 9, 2013

    Dec 6, 2013

    Nov 20, 2013

    Oct 29, 2013

    Sep 25, 2013

    Sep 12, 2013

    Sep 10, 2013

    Jul 31, 2013

    Looking for more? Browse all our products here