House Agriculture Committee Reports Out Derivatives Oversight Bill
The House Agriculture Committee has approved legislation to increase the transparency of and strengthen the oversight of futures, options and over-the-counter (OTC) markets. By voice vote, the Committee approved the Derivatives Markets Transparency and Accountability Act of 2009 as amended, a bill sponsored by Committee Chair Collin Peterson. The bill was referred to the House Financial Services Committee. There is a companion bill in the Senate introduced by Senator Tom Harkin, Chair of the Agriculture Committee. The Harkin bill, S 272, would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges.
The House legislation, H.R. 977, will bring greater transparency and oversight to futures and OTC derivatives markets. It toughens position limits on futures contracts for physically-deliverable commodities as a way to prevent potential price distortions caused by excessive speculative trading. An innovative provision authorizes the CFTC to initiate and conduct criminal litigation for violations of the Act if the US Attorney General has declined to bring criminal proceedings. This is a power the SEC does not have.
From October through December 2008, this Committee held a widely publicized series of hearings on the role unregulated OTC financial derivatives have played in causing the present economic meltdown The draft legislation is designed to apply time-tested tools of market regulation to the OTC energy and financial derivatives markets.
The overwhelming message of the testimony presented to the Committee established a consensus that the previously unregulated OTC markets have caused severe systemic shocks because of a lack of transparency to the financial regulators of these private bilateral agreements, and because of inadequate capital reserves set aside by OTC derivative counterparties to underpin the trillions of dollars of financial commitments they made through the OTC transactions in question.
The bill requires all prospective over-the-counter transactions to be settled and cleared through a CFTC-regulated designated clearing organization, unless exempted by the CFTC in accordance with specified criteria. In some cases, the clearing requirement can met through an SEC regulated clearing agency or a properly regulated foreign clearinghouse. The measure gives the CFTC the authority, with the President’s consent, to suspend naked credit default swap trading whenever an SEC short selling suspension order is in effect.
Importantly, the measure would close the so-called London Loophole by requiring foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade U.S. commodities similar to U.S.-regulated exchanges The bill also imposes a clearing requirement on OTC derivatives contracts and empowers the CFTC to suspend trading in naked credit default swaps under certain circumstances. The bill broadens and improves on last year’s bipartisan derivatives legislation that passed the House by a wide margin.
The measure will also limit eligibility for hedge exemptions to bona-fide hedgers and improve transparency by requiring the CFTC to disaggregate and separately report the trading activity of index funds and swap dealers in agriculture and energy markets. It also calls for new, full-time CFTC employees to enforce manipulation and prevent fraud.
The bill also authorizes the CFTC to take corrective action if it finds disruption in over-the-counter markets for energy and gas. A manager’s amendment by Chairman Peterson, by voice vote, contains technical and clarifying corrections, and changes regarding position limits and CFTC authority to suspend credit default swaps trading.
Section 4 of the bill requires the CFTC to issue a proposed rule defining and classifying index traders and swap dealers for data reporting requirements and setting reporting requirements for transactions in designated contracts markets, derivatives transaction execution facilities, foreign boards of trade, and electronic trading facilities with respect to significant price discovery contracts. The statute also requires the CFTC to disaggregate and publicly provide the number and total value of positions of index funds, and other passive, long-only and short-only investors in all regulated markets, and data speculative positions relative to their bona fide physical hedgers.
The bill also authorizes the CFTC to suspend trading in credit default swaps, with the concurrence of the President. The measure provides that credit default swaps traded or cleared by registered entities will not be considered a federal security except as necessary for enforcing insider trading prohibitions of the Securities Exchange Act.
The Act defines credit default swap to mean a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade.
The bill essentially bans naked credit default swaps, which are those swaps that are merely a wager on the viability of an institution or financial instrument without requiring the corresponding underlying risk from the failure of those institutions or instruments. Former SEC Chair Christopher Cox repeatedly criticized these instruments as naked shorts on public corporations that evade the requirements for shorting stocks in the regulated equity markets.
The draft legislation provides for tailored and limited exemptions that may be granted by the CFTC from the mandatory clearing requirements for individually negotiated derivatives. The precise standards assure that the exemption will only be granted when systemic risks will not be posed. The draft legislation is a reasonable compromise that accommodates individually negotiated contracts that cannot be cleared. By contrast, Senator Harkin’s legislation flatly bans exceptions from this requirement that all OTC contracts be exchange traded, not merely cleared.