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Debate on Derivatives Reform Heats Up

A call for mandatory clearing or pushing all over the counter (OTC) market futures products onto an exchange, particularly nonstandardized products, was one of the main points of dispute among congressmen, financial industry witnesses and critics at an extensive hearing on market reform Thursday before the Senate Committee on Agriculture, Nutrition and Forestry.

The debate came as lawmakers on both sides of the Capitol intensified activity aimed at rewriting the rules for the industry that precipitated the current financial crisis.

Financial industry witnesses fought back against a bill proposed by committee Chairman Tom Harkin, D-IA, saying the measure would increase industry's costs and risks of doing business, and arguing that forcing all transactions to be cleared or onto an exchange would be an obstacle to doing business for a number of companies.

Mark Lenczowski, managing director of J.P. Morgan Chase & Co., said exchange trades do not have the flexibility of collateral available to an OTC product. For instance, an exchange might require cash collateral, while an OTC deal could accept collateral in the form of a client's product. He advocated clearing for all standardized contracts, but simply enhanced reporting for customized deals.

Lenczowski also listed a number of reform measures the finance industry already is working on to improve accountability.

Harkin was not impressed. He said he had heard that defense of industry self regulation once before, several years ago from then Federal Reserve Chairman Alan Greenspan. "Fool me once, your mistake; fool me again, my mistake," Harkin observed. "We must restore proper regulatory oversight if we're going to get this economy built on a solid foundation." Derivatives markets must work properly and in the open as a support for the economy, "otherwise you're just in a gambling game."

David Dines, president of Cargill Risk Management, gave as an example the problem of always hedging with a standardized product for his firm, which buys and processes corn every day. The company's best hedge is against an average corn price, rather than a price at a discrete point in time. "You can't buy that on exchanges; it doesn't exist." Further, Dines said, Cargill's hedges are tailored to an exact protection level and a specific end date. For instance, they may only want to hedge on an average through pollination, rather than harvest and that way save four months of time value. The company's OTC hedging costs run 30-40% less than they would on an exchange. Absent these tailored products Cargill would likely hedge less, thereby increasing its risks.

But Michael Masters, with Masters Capital Management LLC, said there are increased costs to nonstandardized products since banks and dealers can conceal profits and fees. And, with exchange-traded products there can be many more participants in the market, making bids and offers lower.

That financial institutions have been benefiting is shown by the rise in their share of corporate profits, said Lynn Stout, professor at the UCLA School of Law. One study shows that between 1973 and 1985 the financial sector never earned more than 16% of U.S. domestic corporate profit. "During the past decade, however, the finance sector took as much as 41% of all corporate profit. Much of this profit reflects trading gains reaped by hedge funds and proprietary trading divisions of investment banks, which enjoyed these gains at the expense of average investors," Stout said.

Commodity Futures Trading Commission Chairman Gary Gensler, who led off testimony, split the baby on standardized and customized products, saying "we should require that all derivatives that can be moved into central clearing be required to be cleared through regulated central clearing," and included in his testimony "objective criteria" for regulators to determine what is standardized. These include:

The criteria, said Gensler, "could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them 'customized.'"

With all contracts, the CFTC should have clear authority to impose recordkeeping and reporting requirements providing a full audit trail, and margin requirements, and position limits, including aggregate limits, to prevent excessive speculation, Gensler said.

Several witnesses and congressmen argued for stricter controls on commodities markets, particularly in food and energy and where the futures market tends to lead the spot price.

Masters said the energy market now appears to be headed back into the excessive speculation that drove prices last year to 20-year highs while actual demand hit 10-year lows. He said legislation should close all the loopholes, including the swaps loophole and the so-called London loophole. "All OTC commodity derivatives should be cleared through an exchange so they can impose position limits."

Sen. Amy Klobuchar, D-MN, warned that restrictions on the energy markets can't wait. "We already are seeing the movement in commodity prices. We have to look at every available option within our current authorities. Every option should be on the table because as the summer moves forward we might see more movement in these prices."

Klobuchar's comments were supported by a coalition of industry and consumer groups, which papered Congress with calls to rein in speculation in commodity markets. The group's letter to congressional leaders pointed to the recent surge in energy commodity prices, and voiced "growing concern that passively-managed index funds, exchange-traded funds and actively traded hedge funds, swaps and derivatives are turning our commodity markets into a highly volatile asset class."

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