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Debate on Derivatives Reform Heats Up

June 8, 2009
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Two critical issues emerged last week in Capitol Hill debate over futures, over-the-counter (OTC) and derivatives regulatory reform as lawmakers heard witnesses proposing mandatory clearing of all OTC contracts -- or not; and the merging of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) -- or not. Senate committee debate also took a side trip into new charges of possible excessive speculation driving energy commodity prices higher.

The curtain went up on the regulatory reform debate just six days after CFTC Chairman Gary Gensler was sworn in, having finally been approved by the Senate (see NGI, May 25).

A call for mandatory clearing or pushing all OTC market futures products onto an exchange, particularly nonstandardized products, was one of the main points of dispute among congressmen, financial industry witnesses and industry critics at an extensive hearing on market reform Thursday before the Senate Committee on Agriculture, Nutrition and Forestry.

Financial industry witnesses fought back against a bill proposed by committee Chairman Tom Harkin, D-IA, to push all transactions onto an exchange or through a central clearing agent, saying the measure would increase industry's costs and risks of doing business.

Mark Lenczowski, managing director of J.P. Morgan Chase & Co., said exchange trades do not have the flexibility of collateral available to an OTC product. For instance, an exchange might require cash collateral, while an OTC deal could accept collateral in the form of a client's product. He advocated clearing for all standardized contracts, but simply enhanced reporting for customized deals.

Lenczowski also listed a number of reform measures the finance industry already is working on to improve accountability.

Harkin was not impressed. He said he had heard that defense of industry self regulation once before, several years ago from then Federal Reserve Chairman Alan Greenspan. "Fool me once, your mistake; fool me again, my mistake," Harkin observed. "We must restore proper regulatory oversight if we're going to get this economy built on a solid foundation." Derivatives markets must work properly and in the open as a support for the economy, "otherwise you're just in a gambling game."

David Dines, president of Cargill Risk Management, gave as an example the problem of always hedging with a standardized product for his firm, which buys and processes corn every day. The company's best hedge is against an average corn price, rather than a price at a discrete point in time. "You can't buy that on exchanges; it doesn't exist." Further, Dines said, Cargill's hedges are tailored to an exact protection level and a specific end date. For instance, they may only want to hedge on an average through pollination, rather than harvest and that way save four months of time value. The company's OTC hedging costs run 30-40% less than they would on an exchange. Absent these tailored products Cargill would likely hedge less, thereby increasing its risks.

But Michael Masters, with Masters Capital Management LLC, said there are increased costs to nonstandardized products since banks and dealers can conceal profits and fees. And, with exchange-traded products there can be many more participants in the market, making bids and offers lower.

That financial institutions have been benefiting is shown by the rise in their share of corporate profits, said Lynn Stout, professor at the UCLA School of Law. One study shows that between 1973 and 1985 the financial sector never earned more than 16% of U.S. domestic corporate profit. "During the past decade, however, the finance sector took as much as 41% of all corporate profit. Much of this profit reflects trading gains reaped by hedge funds and proprietary trading divisions of investment banks, which enjoyed these gains at the expense of average investors," Stout said.

Gensler, who led off testimony, split the baby on standardized and customized products, saying "we should require that all derivatives that can be moved into central clearing be required to be cleared through regulated central clearing," and included in his testimony "objective criteria" for regulators to determine what is standardized. These include:

The criteria, said Gensler, "could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them 'customized.'"

A former CFTC official agreed that "at first glance, [mandatory clearing] sounds like a prudent way to reduce systemic risks." But, "in reality, mandatory clearing for non-standardized illiquid OTC contracts could actually create more problems. Twisting the arms of clearing houses to handle a concentration of illiquid non-standardized contracts could ultimately endanger the financial integrity of the clearing houses and dramatically increase systemic risk," Greg Mocek, former head of enforcement for the CFTC, told NGI. Mocek now is a partner with McDermott Will & Emery.

Gensler outlined the administration's position that the CFTC should have clear authority for all contracts to impose recordkeeping and reporting requirements providing a full audit trail. Also, there should be capital margin requirements, and position limits, including aggregate limits, to prevent excessive speculation. This involves consistent and close regulation of derivatives dealers "and any other firms whose activities in these markets can create large exposures to counterparties."

Testifying earlier in the week before a Senate appropriations subcommittee, Gensler declined to attribute the recent rise in oil prices to a return of speculative fever. Responding to questions he said "part of what we're seeing is confidence coming back into the market."

Commodity prices can be expected to rise as the markets come out of the recession, Gensler said, and speculation from noncommercials was "not the only cause" of skyrocketing oil prices last year. He appeared before the Appropriations subcommittee on financial services to back up the CFTC's budget request for 2010. Senators noted that the agency would need more money and personnel to pursue a more comprehensive regulatory regime.

The agency currently has a staff of about 500, roughly what it was when it started in 1975, while the market it oversees has grown enormously, from transactions valued at $13 billion to $260 billion. Going forward Gensler said the commission would need between 650 and 700 employees to adequately police the market.

Sen. Susan Collins of Maine, ranking Republican on the subcommittee, quizzed Gensler closely on price speculation, saying fuel oil dealers were back in her office last month complaining that speculators again were driving up the price of home heating oil. Sen. John Testor (D-MT) agreed with her concerns and pressed Gensler to come up with the cause of the recent price rise. Citing his six-day experience in his present post, Gensler deferred, but promised to submit explanations for the record.

Questioned as to the advisability of merging the CFTC with the SEC as some have suggested, the new CFTC chairman said the two have different missions and there is no need to merge just for a merger's sake. The CFTC has the lead expertise on derivatives and Congress needs to pass "significant amendments to the Commodity Exchange Act to bring all of the over-the-counter derivatives marketplace under regulation" that includes standardized products, central clearing and regulated exchanges, Gensler said. The CFTC should be setting aggregate position limits for dealers and should be able to see 100% of transactions.

Collins said comprehensive regulation or a council of regulatory agencies is needed so new products devised by the market don't fall through the cracks. She pointed out that "credit default swaps grew into a market worth trillions of dollars, jeopardizing the entire financial market, and it didn't fall under securities, it didn't fall under insurance." It fell through a swaps loophole that allows financial institutions to evade position limits on swaps. "We need a system where new products don't fall into a regulatory black hole."

Gensler said he would be working with SEC Chair Mary Schapiro and agreed it was "critical that we not have any gaps in regulation." But an agency merger is not the way to go, Mocek agreed. "It is a bad idea. If the administration merges the SEC and the CFTC, they will find out that the world is not flat."

In the Agriculture Committee hearing several witnesses and congressmen argued for stricter controls on commodities markets, particularly in food and energy and where the futures market tends to lead the spot price.

Fund manager Masters said the energy market now appears to be headed back into the excessive speculation that drove prices last year to 20-year highs while actual demand hit 10-year lows. He said legislation should close all the loopholes, including the swaps loophole and the so-called London loophole. "All OTC commodity derivatives should be cleared through an exchange so they can impose position limits."

Sen. Amy Klobuchar, D-MN, warned that restrictions on the energy markets can't wait. "We already are seeing the movement in commodity prices. We have to look at every available option within our current authorities. Every option should be on the table because as the summer moves forward we might see more movement in these prices."

Klobuchar's comments were supported by a coalition of industry and consumer groups, which papered Congress with calls to rein in speculation in commodity markets. The group's letter to congressional leaders pointed to the recent surge in energy commodity prices, and voiced "growing concern that passively-managed index funds, exchange-traded funds and actively traded hedge funds, swaps and derivatives are turning our commodity markets into a highly volatile asset class."

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