Article provided courtesy of Futures Industry Magazine, March/April 2009 Issue
The House Agriculture Committee on Feb. 12 approved H.R. 977, the Derivatives Markets Transparency and Accountability Act of 2009. Although the legislation is a long way from becoming law, it is likely to have an important role in t Congressional efforts to limit speculation in the commodity futures markets and to strengthen regulation and oversight for both listed and over-the-counter derivatives trading.
H.R. 977 builds on similar legislation that Congress considered last year and includes several provisions that are aimed at reducing the influence of trading linked to commodity indices. The bill also seeks to address concerns about the lack of regulation for the OTC derivatives markets in general and credit default swaps in particular. Although the bill no longer contains a ban on “naked” CDS trading, the bill does include a provision that mandates the clearing of all OTC contracts.
Many of the futures-related provisions in H.R. 977 are similar to legislation proposed last year to address the dramatic rise in fuel and food prices in the first half of 2008. Like last year’s legislation, this year’s bill would provide increased resources for the CFTC and would impose strict limits on speculative trading in commodity futures, which many lawmakers blame for the volatility in commodity prices. Although last year’s legislation did not become law-it died in the Senate-it passed the House by a large majority. Representative Collin Peterson, the Minnesota Democrat who chairs the House Agriculture Committee, has cited that support in explaining why he is using that legislation as the starting point for this year’s bill.
H.R. 977 goes well beyond the commodity speculation issue, however. It also contains several provisions that were drafted in response to the credit crisis that swept over the financial markets after the collapse of Lehman Brothers last fall. In particular, the bill mandates OTC derivatives clearing, requires the reporting of OTC transactions to the CFTC, and gives the CFTC the power to suspend purely speculative trading in credit derivatives if the underlying security is subject to a short selling suspension order from the Securities and Exchange Commission.
The emphasis on clearing reflects a general consensus among members of the committee that the U.S. financial system would be more stable if credit default swaps and other OTC derivatives were cleared through a central counterparty. House Agriculture Committee Chairman Collin Peterson, the Minnesota Democrat who drafted the H.R. 977, initially wanted all OTC derivatives to be cleared and a ban on purely speculative trading of credit derivatives. After a number of financial groups argued against these ideas at a series of hearings in early February, Peterson dropped the ban and agreed to provide some exceptions to the clearing mandate. Even so, the bill as approved by the committee would require almost all OTC swaps to be cleared, including not only prospective transactions but also pre-existing contracts that were transacted before enactment. The bill also aims to make the CFTC the primary regulator for OTC derivatives clearing, rather than the Federal Reserve or the SEC.
Another important part of the bill deals with speculative position limits. At present, the CFTC’s role in setting these limits covers only certain agricultural markets; in all other markets the limits are set by the exchanges. The bill would change this by granting the CFTC the authority to set limits for futures and options based on all physically delivered commodities, i.e., adding metals and energy to the existing list of agricultural products. The bill also would extend these limits to positions taken in OTC commodity markets that are “fungible” with exchange-traded contracts. The CFTC would be required to apply these limits if the OTC contracts have the potential to either 1) disrupt an exchange’s price discovery or liquidity, 2) cause a severe market disturbance, or 3) prevent an exchange-traded contract from reflecting supply and demand for the underlying commodity.
To address the concerns about the flow of money into investments linked to commodity futures, the bill requires the CFTC to impose reporting requirements on index traders and swaps dealers that are active in commodity markets. The bill also requires the CFTC to issue monthly report data on the total positions held by index traders in commodity futures and possibly also in OTC markets that are linked to exchange-traded markets. This report would help clarify the size of the positions held by institutional investors in commodity index swaps that are based on futures prices.
The final section of the bill grants the CFTC authority to conduct criminal litigation relating to violations of the Commodity Exchange Act. This new power, which would apply only if the Justice Department declined to pursue the matter, has strong support from CFTC Commissioner Bart Chilton, who has complained that the Justice Department does not pursue a third of the cases that are referred to it by the agency.
Shortly before the Feb. 12 vote, FIA President John Damgard sent a letter to the members of the committee confirming that the FIA supported many provisions in the bill but warning that certain provisions would reduce liquidity in the commodity futures markets, increase the cost of hedging, and drive trading to non-U.S. markets. Damgard expressed similar concerns in greater detail during testimony before the committee on Feb. 3.
Although some of these concerns were addressed by amendments approved by the committee during the vote-for example, the proposed ban on “naked” trading of credit default swaps was removed-the FIA stated that it could not support the bill in its present form. The FIA cited two primary concerns: the bill’s definition of bona fide hedging is overly restrictive; and the exceptions to the OTC clearing mandate are inadequate and unworkable. With respect to the hedging definition, the bill states that trades would not be considered bona fide hedges unless they are a substitute for positions in the “physical marketing channel.” In addition, swap dealers that use futures to offset OTC positions would not qualify as hedgers unless their swap counterparties are physical hedgers. The FIA told the committee that this definition was so narrow that many market participants using futures to manage their risks would have to be treated as speculators and would therefore curtail their activities in the futures markets.
The next step in the legislative process will depend on the Democratic leadership in the House. Several other committees-notably the House Financial Services Committee, the House Energy Committee and the House Judiciary Committee-are expected to review the bill before it goes to the House floor, and that process could result in significant changes. In addition, the House leadership may decide to consider this bill in the larger context of the Obama administration’s proposal for restructuring financial services regulation. The bill therefore is unlikely to become law in its present form. That said, some of the essential concepts of the bill, such as mandated clearing for financial swaps and speculative position limits for commodity swaps, appear to have broad support and could find their way into whatever bill Congress approves to strengthen market regulation and oversight.
Will Acworth is the editor of Futures Industry magazine.
