Natural gas and electric suppliers last Wednesday expressed support for a House discussion draft on regulatory reform that seeks to preserve “the legitimate function” of using derivatives to hedge commodity price risk.

“At first blush, we sense that they’re hearing our concerns,” said Lee Fuller, vice president of government relations for the Independent Petroleum Association of America (IPAA). But he cautioned the discussion draft of the bill, which was issued by Financial Services Committee Chairman Barney Frank (D-MA) earlier this month, is “very nuanced, very detailed,” and will take time to assess its full impact. The 187-page discussion draft calls for greater regulation of the heretofore unregulated over-the-counter (OTC) derivatives market.

The House draft, as well as the Obama administration’s proposal to regulate the $580 trillion OTC market, are “demonstrating end-users need for some flexibility” with respect to using hedging to manage capital, Fuller said. The IPAA also is keeping a close eye on what’s happening to counterparties — banks, financial institutions — because that will affect producers’ hedging activities, he noted.

The IPAA’s Fuller expressed similar optimism in August when the Treasury Department sent the Obama administration’s legislative package to regulate the OTC derivatives market to Capitol Hill (see NGI, Aug. 17).

A coalition of 13 gas and electricity associations, including the IPAA, applauded “the constructive and thoughtful discussion draft put forward by Chairman Frank, which reflects a number of the concerns that we have raised to date. We particularly appreciate the draft bill’s recognition of the importance of maintaining the OTC markets for risk management purposes.”

In a position statement on OTC market reform, the group said it supported the “goals of the administration and the Congress to increase regulation as well as improve transparency and stability in OTC derivatives markets. When discussing any increased regulation of exchange and OTC markets, we believe there should be an appropriate balance between establishing market oversight rules that allow for a broad use of market-based risk management tools while providing regulators with the ability to establish a high level of transparency and the tools needed to protect consumers against market manipulation and systemic risk.”

The House discussion draft “will and I believe should undergo significant change. But you have to start somewhere,” Frank said at a committee hearing last Wednesday on his draft. “This bill will not on the best timetable be signed by the president until December…We will certainly meet a timetable of getting legislation to the [House] floor in November.” The House committee is expected to begin marking up the proposal this week.

Frank said he agreed with some of the criticism of his draft. “It does seem to many of us that there is a distinction between derivatives as an end [for making money] and derivatives as means…so that they can go about their business of producing goods and services with some stability, some reasonable expectations about costs,” he noted.

“Derivatives are a very legitimate way for producers of end products to reduce volatility. Our job is to find a way to preserve that legitimate function while diminishing the excessive volatility that comes from people who are doing it to speculate, from diminishing the risk that comes when people get over-extended,” Frank said.

“I do believe that there is a need to distinguish between legitimate end-users and people who are there because this is a profit center,” the chairman said.

Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), agreed with that sentiment. “A number of end-users that use OTC derivatives for hedging have asked whether their contracts would be required to be cleared. I believe that such end-users should be allowed to fully use customized or tailored contracts to meet their particular hedging needs and that these would not need to be centrally cleared,” he said.

“The only question that remains is: should the end-users’ standard, or clearable, contracts be subject to a clearing requirement? The CFTC has recommended that the swap dealers should bring those transactions to a central clearinghouse to lower risks. The end-user would be allowed to enter into individualized credit arrangements with the financial institutions that enter into transactions with them i.e. their clearing firm. End-users would not be required to post cash collateral or any other particular form of collateral — they would simply be required to work with the clearing firm to determine the most appropriate credit arrangement,” Gensler said.

“To the extent that Congress decides not to follow this approach, I believe that any clearing exception for end-users should be very narrowly defined to only include nonfinancial entities that use swaps incidental to their business to hedge actual commercial risks,” he noted.

“Lacking and lagging regulation of OTC derivatives was a major contributing factor to last year’s [financial] crisis, including the highly leveraged credit default swaps at AIG that prompted government intervention,” said Rep. Melissa Bean (D-IL), a member of the financial services panel and co-chair of the New Democrat Coalition’s Financial Services Task Force. “This [Frank] bill moves us in the right direction by reducing risk to the economy with robust and dynamic oversight of major market participants, while preserving appropriate risk-management tools for end-users.”

The bill would affect entities such as United States Natural Gas Fund (UNG), an exchange-traded fund that invests in swaps. Limits intended to curb speculation by funds have prevented UNG from expanding its holdings in natural gas on the New York Mercantile Exchange and IntercontinentalExchange Inc. The limits have hindered the fund in offering new units to investors (see NGI, Sept. 21).

“A year ago, many critics of derivatives were ready to eliminate the entire over-the-counter market. This reaction was unreasonable and not in the best interest of our economy. The Frank proposal addresses the systemic risk issues by mandating exchange clearing and trading for the majority of products while preserving the over-the-counter market for specialized contracts, in much the same way that the bill I introduced with the New Dems does,” said Rep. Michael E. McMahon (D-NY), member of the New Democrat Coalition.

A recent analysis by Deloitte & Touche LLP cautioned that regulatory reform could have the effect of reducing hedging options and market liquidity. If regulations aren’t harmonized across exchanges internationally, some U.S. trading could migrate overseas, Deloitte said (see NGI, Sept. 21).

Last month Garry O’Connor, chief product officer for the International Derivatives Clearing Group LLC, told the House Agriculture Committee, “The OTC 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.”

The 13-member coalition, which supported the Frank discussion draft, includes America’s Natural Gas Alliance, American Exploration and Production Council, America Gas Association, American Public Gas Association, American Public Power Association, Edison Electric Institute, Electric Power Supply Association, IPAA, Interstate Natural Gas Association of America, Large Public Power Council, National Rural Electric Cooperative Association, Natural Gas Supply Association and U.S. Oil & Gas Association.

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