The House Financial Services Committee last 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 down along party lines. 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 see NGI, Oct. 12).
While initially he believed all derivative transactions should be traded on exchanges, Frank said he changed his mind following “conversations with end-users…who are hedging not because they think it’s a good way to make money, but because they are making product or [providing] a service and want protection against volatility.”
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 committee bill “is a significant step toward lowering risk and promoting transparency,” but he added “substantive challenges remain.” 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 on Wednesday (Oct. 21) will begin marking up its own OTC derivatives measure, which favors more trading on regulated exchanges to achieve market transparency. 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 having to comply 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 by 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 NGI, April 7, 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.
Given the sweeping changes that will be made to the OTC derivatives market as a result of the legislation, Rep. Spencer Bachus of Alabama, the ranking Republican on the committee, proposed that companies be given more than 180 days from enactment to comply with the bill’s requirements. Frank declined to extend the deadline, but agreed that regulators should be given more flexibility with the rulemaking process.
The House Agriculture Committee bill mandates both clearing and exchange trading of derivatives. It would exempt trading parties from third-party clearing if one of the counterparties is not a futures swap dealer or security-based swap dealer, can demonstrate appropriate business/risk management practices for using noncleared futures swaps and security-based swaps, and none of the counterparties are a “Tier 1” (large) financial holding company..
The agriculture panel draft would require futures swaps and security-based swaps that are determined to be cleared to be traded on regulated exchanges or alternative swap executive facilities.
Clearing agencies — self-regulatory clearing corporations and depositories that are required to register with the CFTC — or derivative clearing organizations, such as clearinghouses or clearing associations, would determine which futures swaps and security-based swaps must be cleared. In contrast, Frank proposes that the clearing decision be left up to the CFTC and the SEC.
Under the Obama administration and Frank proposals the Department of Treasury would be called in to settle any dispute between the CFTC and SEC, but the agriculture bill would allow either of the two agencies to petition the U.S. Court of Appeals for the District of Columbia Circuit to review rules that may encroach on the other’s jurisdiction.
With respect to mixed swaps — swaps with both security and futures features — the CFTC and SEC would have dual regulation under the Frank and Obama administration proposal. However, the agriculture draft proposes a “preponderance test” that would assign swap products to either CFTC or SEC regulation depending on what the swap is primarily based on.
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