An early morning compromise Friday on the critical derivatives portion of the all-encompassing financial reform legislation reportedly would require federally insured banks to set up separate entities to trade the riskier types of derivatives, including those dealing with energy, metals and agriculture and credit default swaps, while preserving their ability to make less risky trades in currencies.
The compromise in the U.S. House-Senate conference committee came as the mega-reform measure, the government's answer to the massive economic crisis led by the collapse of banks and Wall Street investment houses, neared final passage, possibly by the Fourth of July (see NGI, June 21). The details have yet to be published, but the outline of the derivatives compromise, the ending of the last big reform battle, came from conference committee lawmakers emerging from a marathon session early this morning.
While the legislation reportedly would refuse government insurance to any bank engaged in derivatives and swaps trading in the risky types of trades such as commodities, it would allow them to continue to use swaps to hedge their own risk on interest rates, gold and silver, or foreign exchange. Banks would have to spin off their riskier trading into separate entities not backed by the federal government.
The panel also agreed on the so-called "Volcker rule," named after Paul Volcker, a former Federal Reserve chairman. That measure would bar banks from trading with their own money, a practice known as proprietary trading, except in limited circumstances.
Other portions of the legislation, such as the requirements for clearing and exchange trading for speculative over-the-counter derivatives, were not at issue in the final negotiations and were expected to emerge as they were agreed to earlier. This would include the exemption for OTC trades by commercial parties.
The conference committee vote, 27 to 16, followed party lines.
"This legislation brings a $600 trillion unregulated derivatives market into the light of day, ending the days of Wall Street's backroom deals and putting this money back on Main Street where it belongs," said Sen. Blanche Lincoln, D-AR, chairman of the Senate Agriculture Committee, who fought long and hard to keep the bills for the banks' derivative trading mistakes from being paid by taxpayers. "These reforms will get banks back to the business of banking, protect innocent depositors and ensure taxpayers will never again have to foot the bill for risky Wall Street gambling."
While the measure is expected to be enacted, the vote will be close in the Senate. As he prepared to leave for the G20 summit in Canada, President Obama, questioned as to whether he expected to get the measure through the Senate, replied, "You bet."
In his prepared remarks the president said the legislation would "put in place the toughest consumer financial protections in our history, while creating an independent agency to enforce them. Credit card companies will no longer be able to mislead you with pages and pages of fine print. You will no longer be subject to all kinds of hidden fees and penalties, or the predatory practices of unscrupulous lenders.
"Wall Street reform will also strengthen our economy in a number of other ways. We'll make our financial system more transparent by bringing the kinds of complex deals that help trigger this crisis, like trades in a $600 trillion derivatives market, into the light of day. We'll enact the Volcker Rule to make sure that banks protected by the safety net of the FDIC can't engage in risky trades for their own profit. And we'll create what's called a resolution authority to help wind down firms whose collapse would threaten our entire financial system. No longer will we have companies that are "too big to fail," the president said.
Looking beyond the final vote, however, Jenny Fordham, director of energy markets and government affairs for the Natural Gas Supply Association (NGSA), said that if the measure is passed, there will be hard work ahead for the industry and the regulatory agencies on implementation.
For instance, sorting out exactly how the commercial exemption to clearing and exchange trading will work still will have to be spelled out. She noted that the commercial exemption is "subject to a company explaining to the Commodity Futures Trading Commission (CFTC) how their financial obligations are met. We're not sure just what that means. A lot of what comes out of this legislation will depend on how the CFTC implements it. This sounds like in order not to clear a swap you have to demonstrate something to the CFTC about how you can meet this obligation without clearing it. Whether that's going to be something as simple as saying, 'I have assets in the ground,' I don't know."
The bill as written requires implementation of the critical items by the CFTC within a year of passage, and the CFTC will likely put industry compliance on an expedited timetable. "We have no idea what the rules are going to look like and we will have to be in a position, probably within two years to be operating under them," Fordham told NGI. "I would think that the industry compliance date might be pretty quick once the rules get finalized. We're in for easily a couple of years of sorting through the implementation, once we know what we're implementing.".
Another one of those critical items for commercial traders of natural gas is how they avoid being classified as "swaps dealers" rather than commercial or non-financial traders, since a number of companies trade to offset product sales and purchases, but also do some non-commercial trades. As written, the legislation includes a de minimis exclusion for companies to avoid the dealer designation and rules. "We think it's positive that the legislation will recognize some flexibility in a company's business portfolio, but depending on the final bill, it could be up to the CFTC to define de minimis," Fordham said.
One clause in the mega-bill at this point would require the CFTC to establish "appropriate" capital and margin requirements for uncleared swaps, such as those by commercial traders. The legislation appears to say that the CFTC can recognize different margin requirements for non-bank swap dealers. "If a margin requirement is high enough it can basically gut the benefit of the clearing exclusion. A margin requirement can add costs to a transaction just like clearing," Fordham said. "We are hoping we can work with the CFTC to establish a process that ensure that margin requirements do not negate the benefit of the clearing exclusion."
The NGSA's Fordham said it appears through these various requirements that the CFTC is going to be much more involved in the risk management practices of a company. And, for instance, if the government looks into a transaction and approves the margining, will the government then be liable if the transaction goes wrong?
©Copyright 2010 Intelligence Press Inc. All rights reserved. The preceding news report may not be republished or redistributed, in whole or in part, in any form, without prior written consent of Intelligence Press, Inc.