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Trading Rules Action Urged to Avert New Crisis

September 21, 2009
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While corporate America is objecting to the costs of a new regulatory regime and central clearing for financial commodities products, the alternative is unacceptable. In the current financial crisis "all the American people are paying the price for it, not just those who instigated the problem," a derivatives market expert told a House committee hearing Thursday.

"The OTC [over-the-counter] derivatives markets currently represent a greater risk to our underlying economy than they did before the financial crisis began, and new rules need to be put in place as soon as possible," said Garry O'Connor, chief product officer for the International Derivatives Clearing Group LLC. Because of attrition among major banks, which are the largest liquidity providers, there is even greater market concentration and risk and higher prices for the transfer of risk.

O'Connor was one of a number of witnesses testifying and responding to questions as the House Agriculture Committee sought to fine-tune regulatory reform legislation for the commodities markets.

"End-users are desperate for a more diverse base of liquidity providers to bring transaction costs back to pre-crisis levels and to provide a buffer to the extreme volatility" in the markets. But they are objecting to rules on clearing and collateral that will provide just such a stable market, he said.

"There is a cost to central clearing, but there is also a great benefit to it, so it's difficult to sit in this room and say, 'I would like to see more transparency in my markets; I would like be protected from systemic risk; I would like more done about abuses to the market that cause undue volatility, but I don't want to pay anything for it,'" O'Connor said.

Responding to questions, the veteran futures trader said some of those complaining of increased costs are those who probably didn't pay much at all in the past to limit their exposure and risk. Those who traded with the failed AIG obviously didn't examine their counterparty's collateral very closely. "There is no way to identify who the next systemically devastating organization may be other than by throwing a wide and thorough regulatory net," O'Connor said.

Arguing for central clearing, he said corporate America should not "simply assume that the government of the day will continue to support their counterparts in the financial system."

The IntercontinentalExchange (ICE) continued to argue in favor of the Commodity Futures Trading Commission (CFTC) setting the rules and administering them directly rather than delegating that authority to approved exchanges, while CME, parent of the New York Mercantile Exchange and one of those approved exchanges, battled away to maintain its authority. CME supports "principles-based" regulation for the CFTC, leaving the exchanges or market operators to spell out the actual rules and administer them.

While the CFTC could set aggregate position limits across OTC and U.S. derivatives markets, regulated exchange operators such as CME would administer the position limits and any tailored hedge exemptions for their own exchanges. CME offered a proposed methodology for setting position limits.

ICE maintains, however, that "a new position limit or accountability level regime established and administered by the CFTC, with the CFTC having sole authority to grant exemptions, may offer greater confidence in market integrity." The CFTC already has the data collection systems in place to monitor market-wide limits, the electronic exchange operator pointed out.

Further, ICE maintains the limits should be "market and exchange agnostic. Setting position limits in the manner suggested by CME, as a percentage of an exchange's open interest, would be anti-competitive," serving as a barrier to entry into the market since it would impose smaller limits for new exchanges.

Also in Washington last week Sen Maria Cantwell (D-WA) introduced legislation that would make it easier for the CFTC to prove manipulation in energy futures markets. The bill would bring the CFTC's burden of proof in line with the lesser standard used by the Securities and Exchange Commission, the Federal Energy Regulatory Commission and the Federal Trade Commission to prove and deter market manipulation.

Current law requires the CFTC to show "specific intent" to do harm to prove manipulation, rather than the "recklessness" standard used by the SEC for the past 75 years, according to Cantwell. Because of the higher bar, the CFTC has successfully prosecuted and won only one case of manipulation in the futures markets in its 35-year history. Cantwell's bill would give the CFTC the same "reckless conduct" standard for manipulation.

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