OTC Derivatives

The extent to which federal sales practice requirements would protect over-the-counter purchasers of complex financial instruments known as derivatives depends in part on whether these products are considered securities, futures, or neither. This report examines the use of these instruments and suggests steps to determine whether federal sales practice requirements should be implemented. GAO discusses the (1) federal sales practice requirements applicable to these products and the dealers marketing them; (2) extent of end-user satisfaction with sales practices, 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) steps that dealers and end-users have taken to reduce the potential for sales practice disputes; and (5) steps that 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.

Recommendations

Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

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