New derivatives rules will spark lobbying battle

The head of the Commodity Futures Trading Commission (CFTC) proposed broad new rules to oversee the trillion-dollar derivatives market that will require congressional approval and set off a heavy lobbying battle.

At a Senate Agriculture Committee hearing on Thursday, CFTC head Gary Gensler outlined a two-part system of regulating derivatives: All dealers of derivatives would face new requirements, while the government would impose new rules on the actual marketplace for derivatives in an effort to ensure transparency.

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“The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust federal regulation,” Gensler said.

The proposal to regulate the shadowy world of financial instruments that many blame for accelerating the financial crisis comes ahead of the Obama administration releasing a more wide-ranging effort to rewrite major parts of the financial system. The administration is expected to release that proposal by mid-June; two sources said that it would occur on June 17.

Derivatives can cover a range of agreements where payment is based upon some agreed-upon benchmark, but in recent years have commonly become associated with those used to hedge against risk.

Now largely unregulated, the derivatives market is made up primarily of bilateral, over-the-counter (OTC) transactions. The face value of those deals was roughly $400 trillion at the end of 2008, according to the International Swaps and Derivatives Association, while credit default swaps (CDS) alone represented $39 trillion, a plunge of 30 percent since the middle of last year.

Those CDS transactions have been heavily criticized for exacerbating the crisis and for bringing American International Group to its knees and costing taxpayers roughly $180 billion in bailout money. Still, derivatives continue to be major source of revenue for Wall Street banks, and new requirements such as those Gensler outlined would cut into potential profit.

Under Gensler’s proposal, dealers would face new capital and margin requirements, rules on business conduct and reporting and recordkeeping standards. Derivatives that were standardized would be cleared through a central clearinghouse and would be placed on exchanges.

Sen. Tom Harkin (D-Iowa), chairman of the Senate Agriculture Committee, wants a more sweeping change. Harkin has a bill that would bring all OTC derivatives onto public exchanges. Harkin said at the end of the hearing that the committee would try to move legislation this year, but “probably not until the fall.”

Left unclear on Thursday is exactly how government regulators would determine the difference between “standard” and “customized” derivatives. Gensler said that there would be a “presumption” that if a clearinghouse accepts an instrument, then it is standardized; he also indicated that regulators would consider factors such as the volume, the similarity in contracts and the extent to which outside parties are aware of the transaction.

Gensler also said that regulators would consider “additional features” of regulation to oversee the CDS market in particular.

“I have a hard time understanding what is so customized that it can’t be put on an exchange,” Harkin said.

Manufacturing and financial interests that use derivatives to hedge risk pounced on how customized derivatives would be treated.

The U.S. Chamber of Commerce and the Business Roundtable on Thursday wrote to Senate Majority Leader Harry Reid (D-Nev.) and Senate Minority Leader Mitch McConnell (R-Ky.) urging them that any legislation “preserves the ability of U.S. companies to use OTC derivatives to manage risk,” particularly customized derivatives.

Meanwhile, Tim Ryan, president of the Securities Industry and Financial Markets Association (SIFMA), said that while “clearing” is an important way to reduce risk in the market, “proposals to standardize all derivatives and force them into clearing or exchange trading would eliminate customized contracts, exposing American business to higher costs, greater risks or both.”

Regulating the derivatives market illustrates the many jurisdictional questions between federal regulators and congressional committees that will come into play as lawmakers push forward to reform the financial system.

The derivatives legislation falls under the jurisdiction of the Agriculture committees in both chambers, as well as the Senate Banking and House Financial Services committees. The CFTC, Securities and Exchange Commission and Treasury Department have all had a hand this year in crafting legislation, while the Federal Reserve regulates the major banks that are the principal dealers of derivatives.