The House Financial Services Committee Thursday approved by a wide margin a measure that calls for sweeping overhaul of the $500 trillion-plus over-the-counter (OTC) derivatives market.

The bill (HR 3795) cleared the panel by a vote of 43 to 26, breaking along party lines (see Daily GPI, Oct. 15). It requires any derivative product that is cleared through a clearinghouse to be traded on an exchange or electronic platform if the derivative contract is between two financial institutions. However, it would exempt end-users — such as energy producers and consumers — from having to trade on exchanges if they use derivative products to hedge commercial risk.

Those who are “end-users, the producers, will have an exemption as long as they are not major swap participants” or engage in a pattern of activity that puts counterparties at risk, said Committee Chairman Barney Frank (D-MA), chief sponsor of the bill. The measure defines a “major swap participant” as anyone who maintains a substantial net position in outstanding swaps other than for hedging commercial risk.

Although exempted from exchange trading, users of derivatives to hedge commercial risk “will have to make public the fact of [their] trade and the pricing. There will be no more hidden trades. There will be no more trades in which we don’t know the price.” The bill imposes strict record-keeping and reporting requirements on traders, as well as greater capital requirements on traders and dealers.

Derivatives, which were blamed for the financial meltdown last fall, are used by energy producers and large consumers to hedge against price fluctuations and other business risks. The bill enhances the Commodity Futures Trading Commission’s (CFTC) and the Securities and Exchange Commission’s (SEC) authority over the heretofore unregulated OTC derivatives market.

CFTC Chairman Gary Gensler said the House committee’s action represents “historic progress toward comprehensive regulatory reform” of the OTC derivatives market. He further said he looked forward to working with others in the House and Senate to “complete legislation that covers the entire marketplace without exception and to ensure that regulators have appropriate authorities to protect the public.”

The House Agriculture Committee will now proceed to mark up its own OTC derivatives measure, which favors more trading on regulated exchanges to achieve market transparency (see Daily GPI, Oct. 13). The two committee bills will have to be reconciled before legislation is sent to the House floor. Frank said he expects the House to vote on legislation by “no earlier than mid or late November. [It will then be] dealt with in the Senate and not enacted until the end of this year” at the earliest.

A commercial hedger who decides to do some financial hedging will not be relegated forever to the exchanges, according to Frank. “The fact that you do some financial hedging does not mean you would always have to trade on the exchange.” A company would not be branded with a “Scarlet Letter,” requiring it to always transact business on exchanges, he said.

The measure would grandfather existing derivatives contracts from complying with the new, more restrictive requirements. This was seen as a compromise to put the new requirements in place without upsetting existing derivative contracts.

Over the objection of Frank, exchanges would continue to set margin requirements rather than transferring that authority to the CFTC and the SEC. This could be changed in the House Agriculture Committee, which has jurisdiction over the CFTC. The House Financial Services Committee does not.

And it calls for a study to be conducted on the “desirability and feasibility” of combining the CFTC and SEC into one agency to regulate the derivatives market (see Daily GPI, April 1, 2008). “I believe strongly if we were starting from scratch that we wouldn’t have two agencies, so I think it’s [the study] reasonable,” Frank said.

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