If you thought derivatives were hideously complex, try following the battle to regulate them. The Obama administration’s reform blueprint, which was released in August, foreshadowed a huge shake-up to the over-the-counter (OTC) derivatives market. All “standardized” OTC derivatives would be cleared and traded on an exchange, and even large industrial firms would incur stricter margining and capital charges on their trades.
Now the House Committees on Financial Services and on Agriculture, each responsible for derivatives oversight, have released diluted proposals of their own. Fewer firms would be covered by margining and capital requirements, and fewer derivatives would be cleared by a central counterparty or traded on exchanges.
Most of the differences hinge on the definition of a “major swap participant.” No one disputes that big banks should observe tighter rules for derivatives trading, but should oil companies, airlines and fund managers, which routinely use derivatives for hedging, face more regulation too? The stakes are high. In the interest-rate and foreign-exchange markets alone, non-financial firms account for about $50 trillion of derivatives outstanding. Earlier this month over 170 firms, including Ford, Shell and Procter & Gamble, wrote a letter to lawmakers bemoaning the “extraordinary burden” they would face if they had to join clearing houses or allocate their precious cash reserves to margin payments.
The latest congressional proposals leave much to be clarified. The Securities and Exchange Commission (SEC) frets that looser rules will let key derivative traders, such as hedge funds, off the hook. Many non-financial firms hold derivative positions far in excess of their hedging needs. The House plans exclude firms that are not “systemically important” or do not expose their counterparties to “significant credit losses.” But as Kevin McPartland of TABB Group, a research firm, points out: “A few years ago AIG would not have been considered systemically important.”
There are two other big points of contention. The lawmakers have watered down the concept of standardized OTC derivatives. The Treasury wanted central counterparties to clear as many OTC derivatives as they could. The committees’ proposals give the SEC and the Commodity Futures Trading Commission (CFTC) more discretion to decide what gets cleared.
Whether cleared OTC derivatives should be traded on an exchange is the other big debating point. The Treasury believes banks dislike exchange-trading platforms because they narrow bid-ask spreads, undermining profitability. Others argue that few OTC derivatives markets are amenable to exchange-trading anyway. “Companies use OTC derivatives like we buy complex holidays from a travel agent,” says Christopher Ferreri of the Wholesale Markets Brokers’ Association, an industry body. “Everyone’s holiday is different and the buyer wants one quoted price.” The Committee on Financial Services removed the exchange-trading requirement (but may backtrack); the Agriculture Committee diluted the definition of an exchange.
All three proposals maintain the cumbersome supervisory split between the SEC and the CFTC. The SEC would regulate derivatives tied to individual securities, and the CFTC much of the rest. This, for instance, leaves CDSs for a single company within the SEC’s purview, but those for an index of many companies with the CFTC. The Treasury hopes the House will have passed a combined bill by the end of November. That just leaves the Senate.