The Senate last Wednesday fought back Republican efforts to replace a controversial provision that would force large banks and financial institutions to spin off their lucrative derivatives business. However the Democratic provision still remains on shaky ground, given the mounting opposition to it from a number of quarters. It may soon be purged from the broad bill overhauling the financial regulatory system (S., 3217).

The Republican amendment, offered by Sens. Judd Gregg of New Hampshire, Saxby Chambliss of Georgia and Richard Shelby of Alabama, sought to kill the legislation’s prohibition on any kind of federal assistance (including federal deposit insurance and access to the Federal Reserve discount window) to swap dealers, such as Wall Street banks, that engage in derivative transactions. The existing language in the Democratic bill would likely force the banks to shed most of their derivatives operations.

The amendment failed along party lines 39-59. No more action is expected on the legislation until after the Tuesday primary elections.

The Republicans sought to substitute the language crafted by Sen. Blanche Lincoln (D-AR), chair of the Senate Agriculture Committee (see NGI, April 26). The Obama administration, other Democrats, federal financial experts, Wall Street lobbyists and the oil and natural gas industry have expressed reservations about the Lincoln proposal, which could significantly restrict swap trading by large Wall Street banks — such as JPMorgan Chase & Co. and Goldman Sachs Group.

Federal Reserve Chairman Ben Bernanke said the Lincoln measure was “counter-productive” to achieving the goals of financial regulatory reform. It “would essentially prohibit all insured depository institutions from acting as a swap dealer or a major swap participant — even when the institution acts in these capacities to serve the commercial and hedging needs of its customers or to hedge the institution’s own regulation of derivative activities,” he wrote in a a letter to Senate Banking Committee Chairman Christopher Dodd (D-CT), the chief architect of the legislation, and Sen. Richard Shelby of Alabama, the ranking Republican on the Senate banking panel.

Chairman Sheila Bair of the Federal Deposit Insurance Corporation (FDIC), Comptroller of the Currency John Dugan and Paul V. Volcker, former Federal Reserve chairman and White House economic policy adviser, have spoken out against the Lincoln provision to separate banks and their derivative operations.

Because criticism is mounting, Dodd is expected to excise the Lincoln provision on separating banking and derivatives operations, but it’s not likely to come until after the tough May 18 primary election that Lincoln faces in Arkansas, reported CQ Today.

The oil and natural gas industry does not support Lincoln’s banking/derivatives proposal because it would affect the availability of counterparties to hedge commercial risk and the availability of capital, a producer group official said. It’s estimated that it would cost financial institutions approximately $250 billion to set up separate swap desks under Lincoln’s provision, according to Gregg.

The broad reform bill would curb commodities market speculation by forcing over-the-counter (OTC) derivatives trades onto regulated exchanges and clearinghouses. It makes an exemption to the trading/clearing requirement for end-users who use derivatives to hedge the risk associated with trading of physical products. This part of the bill is widely supported by producers, industrial customers and others, but “you have to have somebody to trade with” in order to hedge risk, said the producer official, referring to the part of the Lincoln proposal that would limit the availability of counterparties.

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 (CFTC).

The Senate has passed by voice vote an amendment, which was sponsored by Sen. Maria Cantwell (D-WA), that would bring the CFTC’s burden of proof for market manipulation in line with the lesser standard used by the Securities and Exchange Commission (SEC) for more than 75 years.

Current law requires the CFTC to meet a higher standard in order to prove manipulation — it must prove “specific intent” to do harm on the part of the violator. In contrast, the SEC has only to reach the lower standard of “recklessness” to prove manipulation. Because of the higher legal hurdle for the CFTC, the agency has successfully prosecuted and won only one case of manipulation in the futures markets in its 35-year history. Cantwell’s amendment, which is based on a bill she proposed in 2009, would give the CFTC the same “reckless conduct” standard for manipulation.

“For years the Commodity Futures Trading Commission has lacked the tools necessary to deter and fight manipulation,” Cantwell said after the Senate passed her amendment.

“With the Senate passing this measure unanimously, I believe we are well on our way to restoring accountability in our financial markets. This amendment will draw a bright line that will deter bad actors and if manipulation does happen in the future, there will be a price to be paid,” she said.

CFTC Commissioner Bart Chilton has long been a proponent of changing the standard. “I think we need to, at the CFTC, seriously consider changing our manipulation standard…The SEC has an easier legal hurdle to jump, and I think this may be a great opportunity to adjust our rules to be more in line with theirs,” he said in New York last September.

The existing “specific intent” standard “is a very difficult standard to reach. You’d have to have a pretty dumb individual to, for example, write in an e-mail that you specifically intend to manipulate prices. But that’s what our law currently requires,” he said.

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