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House Passes Bill to Regulate OTC Market, Set Position Limits

Driven by the financial market excesses that led to the recent collapse of major financial institutions, the U.S. House of Representatives Friday passed by a vote of 223 to 202 a financial regulatory reform bill that would regulate over-the-counter (OTC) derivatives for the first time, set position limits for futures commodity trading, create a Consumer Financial Protection Agency and set an orderly process for winding down large, failing non-bank financial institutions.

The omnibus bill, a combination of legislation emerging from the House Agriculture and Financial Services committees after months of negotiations, passed on the House floor after three days of debate (see NGI, Oct. 26). If enacted, the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) would set up a new central consumer watchdog agency with broad oversight power over everything from banks and non-bank financial institutions to consumer credit and mortgages.

It would greatly expand the regulatory powers of the Commodity Futures Trading Commission (CFTC) and its responsibility for limiting excessive speculation in the commodity markets. A Senate committee is considering similar legislation, but it is unlikely to be introduced on the Senate floor until next year (see NGI, Nov. 16).

The 1,300-page measure calls for increased market transparency, reporting and record keeping, as well as transparency of offshore trading. It also addresses jurisdictional issues in the context of swaps by providing for CFTC jurisdiction over commodity swaps and SEC jurisdiction over swaps that are primarily based on securities.

"I commend the House of Representatives for passing historic, landmark legislation that, for the first time, will bring regulation to the over-the-counter derivatives marketplace," CFTC Chairman Gary Gensler said. "The bill comprehensively regulates swap dealers and major swap participants and lays out the framework for the use of clearinghouses and transparent trading facilities. I look forward to continuing to work with Congress on this critical issue as the bill moves to the Senate."

While preserving an exemption for commodity trades involving end-users or commercial traders hedging bona fide commercial risk, the House bill aims to bring transparency to commodity futures and derivatives trading by requiring all non-exempt OTC derivative products transactions to be centrally cleared and traded on regulated exchanges.

"This bill is about closing loopholes, increasing transparency and setting position limits to help reduce excessive speculation," said Paul Cicio, president of the Industrial Energy Consumers of America. "It is aimed at returning the market to where supply and demand is going to determine price rather than speculators."

The Independent Petroleum Association of American (IPAA) had no major quarrel with the bill. "We're very happy with the bill. If you accept that the derivatives market is going to be regulated, then this is acceptable," said Susan Ginsberg, IPAA regulatory vice president.

Commercial traders, including producers and end-users, dodged a bullet when a House vote late Thursday soundly defeated an amendment by the bill's manager, Chairman Barney Frank (D-MA), that would have given the CFTC and the Securities and Exchange Commission (SEC) the authority to set margin and security requirements for commercial traders. Industrial and producer groups had argued against the measure, saying it would materially add to the costs of their risk management programs.

Another late amendment replaced the original definition of "major swap participant" with the definition that was reported out of the House Agriculture Committee. It essentially gives the CFTC more latitude in determining how broadly the definition would be applied rather than having it prescribed by Congress. Large commercial traders, which do a wide variety of trades, had argued in support of this amendment.

Under another amendment to the bill approved late Thursday the CFTC would define the terms "commercial risk," "operating risk" and "balance sheet risk" for purposes of the Commodity Exchange Act.

The manager's amendment to the bill provides in part that "clearing is not required if one of the counterparties is not a swap dealer or major swap participant and can demonstrate business or risk management practices for non-cleared swaps. Swaps that must be cleared must also be traded on exchange or on a swap execution facility (SEF). Voice brokers are still permitted to enter and execute swaps subject to the clearing requirement so long as they process the swap though a regulated exchange or SEF. Uncleared swaps must be reported to a swap repository or to the regulator."

The amendment further requires swap dealers and major participants to maintain capital appropriate to the risk associated with their non-cleared swaps. They also must meet margin requirements to help ensure their own safety and soundness, and which are appropriate for the risk associated with the non-cleared swaps they hold as a dealer or major participant. Dealers must also segregate funds or property associated with an uncleared swap at their counterparties' request.

Under the bill the CFTC would be required to establish position limits on swaps that perform a significant price discovery function and require aggregate limits across markets. It further requires the CFTC to establish position limits on futures transactions for physically deliverable commodities that are applicable to spot month, each month, and all months aggregated, and to hold hearings on such position limits. The CFTC is also authorized to provide exemptions to position limits.

Battling Treasury Secretary Timothy Geithner, who has repeatedly opposed exempting commercial traders from clearing and/or exchange trading requirements, natural gas and power market organizations lobbied hard at the end to keep the commercial trader exemption in the bill. Early last week all the major natural gas and electric power organizations joined in a letter to House members urging support for the exemption for end-users or commercial traders going into the derivatives or swaps market to hedge their own activities in the physical gas and power markets.

The group also opposed the amendment that would have imposed margins or security requirements for end users, saying it would add additional costs to their hedging transactions. Signing the letter were the American Gas Association, American Public Gas Association, American Public Power Association, American Wind Energy Association, America's Natural Gas Alliance, Edison Electric Institute, Electric Power Supply Association, Independent Petroleum Association of America, Natural Gas Supply Association (NGSA) and the National Rural Electric Cooperative Association.

Mandatory exchange trading "would cost the energy industry alone tens of billions of dollars," said NGSA President Skip Horvath, in another letter to Congress earlier this month. It also would "effectively drive smaller participants out of the market and centralize risk." The gas industry leaders were among a large group of industrials and traders in other commodities market who successfully lobbied to dodge the more restrictive elements of the bill.

"There is no suggestion that energy/electricity OTC [over the counter] transactions were implicated in the financial crisis or pose future systemic risks," the group letter stated. "Our members do not pose systemic risk to the broader economy. In fact, the entire commodity market is less than 1% of the global OTC derivatives market, and the energy commodity portion is yet a fraction of that 1%."

Analysts have estimated that the big losers from transparent clearing will be large banking and trading firms such as JP Morgan Chase, Goldman Sachs, Bank of America, Citibank and HSBC, which process trades and profit on the non transparent gap or bid-ask spread between what they charge customers and what they pay to hedge the trades.

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