Regulation of over-the-counter derivatives is essential as the US government tries to prevent market manipulation, the chiefs of two key financial regulatory commissions told the US House Agriculture Committee on Sept. 22.
Noting that a year has passed since the domestic financial system nearly collapsed as several major investments through complicated financial instruments went sour, US Commodity Futures Trading Commission Chairman Gary G. Gensler and US Securities and Exchange Commission Chairwoman Mary C. Schapiro each said the lack of OTC derivative market regulation was only one of several serious weaknesses in US financial regulation.
But it was a significant weakness and it should be corrected, they continued. "It is critical that we work together to enact legislation that will bring greater transparency and oversight to the OTC derivatives market," Schapiro said in her opening statement. "The derivatives market has grown enormously since the late 1990s to approximately $450 trillion of outstanding nominal amount in June 2009."
Gensler said comprehensive OTC derivate market reform will require two complementary regimes: one for derivatives dealers and one for the markets themselves. "This regulatory framework must cover both standardized and customized swaps. It should include all the different products, such as interest rate swaps, currency swaps, commodity swaps, equity swaps, and credit default swaps, as well as all of the derivative products that may be developed in the future," he said.
"We should eliminate exclusions and exemptions from regulation for OTC derivatives. Congress should extend the regulatory regimes of the Commodity Exchange Act and the federal securities laws to fully cover OTC swaps in all commodities," Gensler said, adding, "I believe that the law must cover the entire marketplace, without exception."
Impetus for reform
Congressional and other critics of the current system have contended that speculators used financial swaps and other instruments during 2008's first half to drive oil prices to a record peak after moving their money from a crumbling domestic real estate investment arena. The US Department of the Treasury sent legislative language to Congress on Aug. 11 that would institute regulation of all OTC derivatives. Oil and gas as well as other industries have argued that regulating commodities too strictly could reduce their ability to hedge prices and drive their operating costs higher.
"Public gas systems depend upon both the physical commodity markets as well as the markets in OTC derivatives to meet the natural gas needs of their consumers," David Schryver, executive vice-president of the American Public Gas Association, told the House Agriculture Committee Sept. 17 at an earlier commodities market reform hearing. "By using both markets, these public gas systems are able to purchase firm deliveries of gas from a diverse set of suppliers while hedging the risk of future market price fluctuations."
Proposals to require all standardized OTC derivatives to be cleared (which Gensler said he supports on Sept. 22) would make it much harder for municipal and other public gas systems to use these gas supply strategies, Schryver continued.
Many APGA members with very high credit worth are not required to post collateral for an agreed-upon number of transactions under the current system, he explained. Mandated clearing of all OTC transactions would require them to post an initial margin for all transactions and to meet potential margin calls whenever required on little notice, putting a significant financial burden on the systems and the communities and customers they serve, Schryver said.
He and other witnesses said at the Sept. 17 hearing that while they recognize the need to impose position limits and other restrictions to prevent excessive commodities speculation, exemptions also will be needed in many cases for market participants which are trying to control their fuel or feedstock costs.
Unaffordable costs
"Our primary concern with the Treasury Department's proposal is that it would require most of our transactions to be cleared since our natural gas trades would be considered 'standardized,'" said Glenn English, president of the National Rural Electrical Cooperatives Association. Emphasizing that the group does not want to hedge in an unregulated market and wants derivatives trading to transparent and free of manipulation, he said that most rural electrical co-ops would be able to continue hedging if all derivatives contracts must be cleared.
"Commodity markets were created for the benefit of physical hedgers, and they must continue to remain accessible to them," said Richard B. Hurst, senior vice-president and general counsel for Delta Air Lines Inc., who also testified on the American Air Transport Association's behalf. "In a trade where at least one party is a legitimate physical hedger in a commodity, the committee should consider provisions that would enable these transactions to occur with little additional financial burden on the parties involved."
Jon Hixson, federal government relations director at Cargill Inc., said the food and agricultural service company's businesses include risk management products for bakeries, restaurants, and heating oil suppliers.
"Under the Treasury Department's proposal, it is highly likely that Cargill would be forced to greatly reduce, if not eliminate, offering our customers these risk management solutions…. In addition, we would expect prudent hedging to decline significantly in those situations where Cargill, like other end-users, manages its own commodity, interest rate, and foreign exchange risks due to the imposition of mandatory margining and the drain on working capital," he indicated.
But Gensler, at the Sept. 22 hearing, said CFTC should have authority to set aggregate position limits across all markets and trading persons on traders of OTC derivatives which perform or affect a significant price discovery function in markets that the commission oversees. "This will ensure that traders cannot evade position limits by moving to a related exchange or market," he told the committee. "Exemptions to position limits should be limited and well defined."
More transparent
Moving standardized OTC trades onto regulated exchanges and trade executive facilities would make markets more efficient and transparent, Gensler said. "Exchanges greatly improve the functioning of the existing securities and futures markets. We should bring the same transparency and efficiency to the OTC swaps markets," he said.
Schapiro said Congress should consider modifying the Treasury Department's proposal so that securities-related OTC derivatives are regulated like securities, and commodity and other non-securities-related OTC derivatives are treated like futures.
"At the core of this approach is that similar products should be regulated similarly, or equivalently, if possible," Schapiro explained. Oil and gas swap contracts or other commodity-related OTC derivatives would be regulated in a manner similar to the underlying oil and gas or other futures, she said.
Meanwhile, US Sen. Maria E. Cantwell (D-Wash.) introduced a bill on Sept. 17 that she said would make it easier for CFTC to investigate and punish alleged commodities market manipulation. The measure, which was cosposored by Sen. Bill Nelson (D-Fla.), would replace the requirement for the commodities regulator to prove "specific intent" to do harm with the same "reckless conduct" standard which the SEC has used for 75 years, and the Federal Energy Regulatory Commission and Federal Trade Commission recently adopted, she said.
"When bad actors like Enron and Amaranth Advisors manipulate commodities prices, Americans end up footing the bill, paying more for commodities like oil, gasoline, heating oil, food, and natural gas," Cantwell said. "Unfortunately, regulators lack the tools to protect us from market manipulation in critical commodity futures markets. Through this tough new language, we can establish a clear, bright line against illegal market manipulation and can empower regulators to effectively enforce and deter market manipulation."
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