The legislative language on regulation of the over-the-counter (OTC) derivatives market remains a question mark as the Senate Banking Committee heads into mark-up of a measure proposing major reform of the financial regulatory system.

The proposal, which was unveiled last Monday by Committee Chairman Christopher J. Dodd (D-CT), contained "pretty much what he [Dodd] had" on OTC derivatives regulation in the discussion draft that was circulated last November, said Susan Ginsberg, vice president of crude oil and natural gas regulatory affairs for the Independent Petroleum Association of America (IPAA) (see NGI, Nov. 16, 2009). The initial draft allowed OTC derivatives to be exempted in certain cases from mandated central clearing and trading on regulated exchanges.

The language on OTC derivatives regulation may be replaced if Sens. Jack Reed (R-RI) and Judd Gregg (R-NH), who have headed up a working group on OTC derivatives at Dodd's direction, offer a substitute amendment on derivatives regulation to the full committee during mark-up, which begins March 22.

Dodd's "waiting for an agreement from Reed and Judd...He's trying to keep the ball rolling," Ginsberg said.

"The derivatives portion of the reform bill has not appeared to be a sticking point in broad financial reform...But it does not appear that they [OTC derivatives group members] had come to an agreement on how to regulate derivatives, specifically on how to craft an exception from clearing for end-users," wrote Ginsberg in the IPAA's "Washington Report."

"We expect there to be some form of exemption" -- if not from the Senate Banking Committee, then from the Senate Agriculture Committee -- for end-users, such as large consumers and producers, from mandatory clearing if they use derivative products to hedge commercial risk, she said. "IPAA will continue [its] efforts to ensure that natural gas and oil producers can continue to use the over-the-counter market to manage risk," Ginsberg added.

"We're not sure what will come out of the Senate Banking Committee" in the way of exemptions, she said. Gregg has indicated his support for an end-user exemption. In a note to clients last Monday, Morgan Stanley analysts said, "We believe that the [Reed-Gregg] amendment will take some decision-making away from regulators in determining what products are cleared." The analysts are "awaiting stricter language" from the two senators.

"We're more hopeful on the Agriculture Committee side that there will be an exemption for end-users," Ginsberg said. The agriculture panel has jurisdiction over the Commodity Futures Trading Commission (CFTC).

The Senate Agriculture Committee is expected to unveil its own OTC derivatives bill either later this month or in early April. The IPAA said it has received assurance from Agriculture Committee Chairman Blanche Lincoln (D-AR) and staff that the panel's bill will provide an end-user exemption.

"I think we can get agreement on the derivatives section," said Dodd, who stood alone in unveiling his draft on Capitol Hill last Monday. It's believed that he has little, if any, support from Republicans on the committee for his financial reform bill. As for the committee Democrats, "my hope is that they'll be supportive of this," Dodd told reporters.

Given that there are only 60-70 legislative days remaining in this session of Congress, he said "there is a sense of urgency" to get financial reform legislation passed on Capitol Hill. "We do need to act...I believe the will exists to get this bill adopted."

Dodd's draft in November required OTC derivative products to be centrally cleared and traded on regulated exchanges if they do not receive an exemption from federal regulators overseeing the futures and securities markets. It mirrors language in the House financial reform bill, which passed in December (see NGI, Dec. 14, 2009).

The draft would allow the CFTC and the Securities and Exchange Commission (SEC) to exempt a derivative swap from the clearing-trading requirements if one of the parties to the swap is not a swap dealer or a major swap participant, or no derivative clearing organization will accept the swap for clearing. Uncleared swaps would be subject to margin requirements, and all trades would have to be reported so regulators can monitor risks.

The Industrial Energy Consumers of America (IECA) oppose being required to put up the margin requirements and clear transactions. "That is unresolved. That is a huge question mark for us," said IECA President Paul Cicio.

Greater regulation is needed because the size of the OTC derivatives market has exploded to $592 trillion from $91 trillion in the past decade, according to Dodd's office. And the OTC derivatives were blamed in part for the financial meltdown in 2008. Cicio noted that manufacturers represent only 5% of the overall OTC derivatives transactions, and weren't the cause of any of the problems.

"Over-the-counter derivatives are supposed to be contracts that protect businesses from risks, but they became a way for traders to make enormous bets with no regulatory oversight or rules and, therefore, exacerbated risks [in 2008]," Dodd said.

The U.S. Chamber of Commerce last Tuesday said it was disappointed with Dodd's proposed reforms, citing the measure's failure to attract bipartisan support in the Senate.

"This bill takes three steps backwards with the hope of making future progress," said David Hirschmann, president of the U.S. Chamber's Center for Capital Markets Competitiveness. "It's time for Congress to put politics aside and come together on a bipartisan basis to restore confidence and certainty to the markets, reform our broken regulatory structure, and help us get back on track toward a strong economy."

Among its major concerns, the chamber will continue to oppose a new independent consumer financial regulator that will reduce access to credit for businesses and consumers, the federalization of corporate governance, and a permanent bailout fund, according to Hirschmann. It also will work to support greater transparency for OTC derivatives without jeopardizing the ability of business end-users to effectively manage their risks, he said.

"It's important to get this done, but it's even more important to get it right. It's been 75 years since the last major overhaul of our financial regulatory structure," said Hirschmann.

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