The Senate late Thursday passed historic, broad-based legislation that calls for a sweeping overhaul of the nation's financial regulatory system, including regulation of the over-the-counter (OTC) derivatives market for the first time.

The bill cleared the Senate by a partisan vote of 59-39, with four Republicans voting in favor of the measure, which contains derivatives provisions that are both supported and opposed by oil and natural gas producers, industrial users and manufacturers. The Senate and House will now move to reconcile their respective bills in conference (S. 3217, HR 4173), a process that should be a doozy. The House passed its financial regulatory reform bill in December (see Daily GPI, Dec. 14, 2009).

"There's no doubt that during that time [conference], the financial industry and their lobbyists will keep on fighting" to weaken the reform bill, said President Obama Thursday following the successful cloture vote, which cleared the way for a final vote on the Senate bill. "I will ensure that we arrive at a final product that is both effective and responsible -- one that holds Wall Street to high standards of accountability and secures financial stability."

Senate passage of the 1,400-page financial regulatory reform bill was a major victory for Obama, who has been working, along with Senate leadership, toward this goal since the credit and financial meltdown in late 2008.

Of key interest to the energy industry, the bill seeks to curb commodities market speculation by forcing OTC derivatives trades onto regulated exchanges and clearinghouses. It provides an exemption to the trading/clearing requirement for large commercial traders who use derivatives to hedge the risk associated with trading of physical products.

Derivatives are financial instruments whose price depends upon or is derived from one or more assets, such as energy. Their value is determined by fluctuations in the underlying value. They are mostly used to hedge commercial risk but also can be used for speculative purposes. Some derivatives, such as agricultural commodities, are already traded on regulated exchanges. But OTC derivatives are traded off-exchange and out of the purview of the Commodity Futures Trading Commission. Misuse of derivatives was blamed in part for the financial crisis of 2008.

Specifically, the exemptions would apply to end-users (and their affiliates) who use OTC derivatives to hedge the risk associated with commodities, as well as the manufacturers of goods, and they would apply to a broad array of commodities, including oil, natural gas, electricity and coal.

The derivatives language in the legislation, which was largely drafted by Senate Agriculture Committee Chair Blanche Lincoln (D-AR), retains a provision that would require big banks, such as JPMorgan Chase, Goldman Sachs and Citibank, to either shed or spin off their lucrative derivatives trading desks (see Daily GPI, April 22). This provision was widely opposed by Republicans, who were unsuccessful in a concerted campaign to strike it.

The bill would refuse the banks access to Federal Deposit Insurance Corp. (FDIC) guarantees and the Federal Reserve discount window in connection with their trading of derivatives (see Daily GPI, April 16). This language could be changed in the House-Senate conference.

"I was proud to craft the bill's strong derivatives title. My legislation brings a $600 trillion market into the light of day and ends the days of Wall Street's backroom deals...I will continue to stand up to Wall Street lobbyists and special interest groups to advocate for these reforms as we work to get this bill signed into law," said Lincoln, who faces a tough run-off election in early June.

A manager's amendment to strike Lincoln's controversial provision was not offered after Senate Banking Committee Chairman Christopher Dodd (D-CT), the chief architect of the financial regulatory reform bill, and Sen. Richard Shelby of Alabama, the ranking Republican on the banking panel, failed to reach a deal, CQ Today reported..

Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair, Comptroller of the Currency John Dugan and Paul V. Volcker, former Federal Reserve chairman and White House economic policy adviser, spoke out strongly against Lincoln's proposal.

The provision also has raised concerns among the bona fide hedgers of commercial risk. "Our concern is it [the language] would reduce the number of counterparties with which we could trade" and the availability of capital, said Susan Ginsberg, regulatory vice president of the Independent Petroleum Association of America.

It's estimated that it would cost financial institutions approximately $250 billion to set up separate swap desks under Lincoln's provision, according to Sen. Judd Gregg (R-NH).

Sen. Robert Corker (R-TN) said the bill raises "great questions" about capital being tied up as a result of the major banks being required to set up separate derivatives desks. He further noted that the measure would add $17-23 billion to the national debt.

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