There were no real surprises for regulation of over-the-counter (OTC) derivatives in the draft that Senate Banking Committee Chairman Christopher J. Dodd (D-CT) unveiled Monday calling for a sweeping overhaul of the financial regulatory system. That’s because the OTC derivatives language of the banking measure is still being hammered out.

As a result, Monday’s draft contained “pretty much what he had” on OTC derivatives regulation in the discussion draft that was circulated in November, said Susan Ginsberg, vice president of crude oil and natural gas regulatory affairs for the Independent Petroleum Association of America (IPAA) (see Daily GPI, Nov. 11, 2009).

The November draft language on OTC derivatives regulation is acting as a kind of placeholder in the latest draft until Sens. Jack Reed (R-RI) and Judd Gregg (R-NH), who have headed up a working group on OTC derivatives at Dodd’s direction, offer a substitute amendment on derivatives regulation to the full committee next week, when mark-up of the bill is expected to begin.

“He’s waiting for an agreement from Reed and Judd…He’s trying to keep the ball rolling,” she noted.

“The derivatives portion of the reform bill has not appeared to be a sticking point in broad financial reform…But it does not appear that they [OTC derivatives group members] had come to an agreement on how to regulate derivatives, specifically on how to craft an exception from clearing for end-users,” wrote Ginsberg in the IPAA’s “Washington Report.”

“We expect there to be some form of exemption” — if not from the Senate Banking Committee, then from the Senate Agriculture Committee — for end-users, such as large consumers and producers, from mandatory clearing if they use derivative products to hedge commercial risk, she said. “IPAA will continue [its] efforts to ensure that natural gas and oil producers can continue to use the over-the-counter market to manage risk,” Ginsberg added.

“We’re not sure what will come out of the Senate Banking Committee” in the way of exemptions, she said. Gregg has indicated his support for an end-user exemption. “We’re more hopeful on the Agriculture Committee side that there will be an exemption for end-users.” The agriculture panel has jurisdiction over the Commodity Futures Trading Commission (CFTC).

The Senate Agriculture Committee is expected to unveil its own OTC derivatives bill either later this month or in early April. The IPAA said it has received assurance from Agriculture Committee Chairman Blanche Lincoln (D-AR) and staff that their bill will provide an end-user exemption.

“I think we can get agreement on the derivatives section,” said Dodd, who stood alone in unveiling his draft on Capitol Hill. It’s believed that he has little, if any, support from Republicans on the committee for his financial reform bill. As for the committee Democrats, “my hope is that they’ll be supportive of this,” Dodd told reporters.

Given that there are only 60-70 legislative days remaining in this session of Congress, he said “there is a sense of urgency” to get financial reform legislation passed on Capitol Hill. “We do need to act…I believe the will exists to get this bill adopted.”

Dodd’s draft in November required OTC derivative products to be centrally cleared and traded on regulated exchanges if they do not receive an exemption from federal regulators overseeing the futures and securities markets. It mirrored language in the House financial reform bill, which passed in December (see Daily GPI, Dec. 14, 2009).

The draft would allow the CFTC and the Securities and Exchange Commission (SEC) to exempt a derivative swap from the clearing-trading requirements if one of the parties to the swap is not a swap dealer or a major swap participant, or no derivative clearing organization will accept the swap for clearing. Uncleared swaps would be subject to margin requirements, and all trades would have to be reported so regulators can monitor risks.

The Industrial Energy Consumers of America (IECA) oppose being required to put up the margin requirements and clear transactions. “That is unresolved. That is a huge question mark for us,” said IECA President Paul Cicio.

Greater regulation is needed because the size of the OTC derivatives market has exploded to $592 trillion from $91 trillion in the past decade, according to Dodd’s office. And the OTC derivatives were blamed in part for the financial meltdown in 2008. Cicio noted that manufacturers represent only 5% of the overall OTC derivatives transactions, and weren’t the cause of any of the problems.

“Over-the-counter derivatives are supposed to be contracts that protect businesses from risks, but they became a way for traders to make enormous bets with no regulatory oversight or rules and, therefore, exacerbated risks [in 2008],” Dodd said.

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