Derivative Regulation Bill Passes House Panel

NU Online News Service, Oct. 15, 1:39 p.m. EDT

WASHINGTON–In legislation spurred by the near-collapse of American International Group, the House Financial Services Committee approved a bill today to significantly increase federal regulation of the credit default swaps trading.

The Over-the-Counter Derivatives Market Act of 2009 was reported out of the Committee by a 43-26 vote. Only one Republican, Rep. Walter Jones, R-N.C., joined all committee Democrats in passing the measure.

It now goes to the House Agriculture Committee, which has oversight over the Commodities Futures Trading Commission.

That panel has drafted a similar, but not companion bill. The bill will not go to the House floor before both panels agree on a single piece of legislation. It will act on its bill next Wednesday.

Rep. Barney Frank, D-Mass., chairman of the FSC panel, said he hopes the bill can be signed by the end of the year.

Under legislation strengthened through amendment Wednesday, the bill mandates that trades between major financial players — such as banks, hedge funds and AIG's Financial Products Group — must be placed on exchanges.

AIG trading in derivatives led to billions in losses requiring the government to step in and rescue the firm by taking a 79.9 percent stock interest in the conglomerate.

Under the bill, trades by end-users such as airlines, manufacturers and farmers, which use them to hedge against business risk, would be exempt. These would include life insurance companies, who use these to reduce their interest rate and capital loss risk on long-term securities used to fund insurance policies, annuities and other products.

A major backdrop to Tuesday and Wednesday's debates by lawmakers and during a hearing on the issue last week was the collapse of AIG. Its inability to meet margin requirements forced the Treasury Department and the Federal Reserve Board to loan the company $85 billion last September in exchange for taxpayers taking a stake.

Former AIG Chief Executive Officer Edward Liddy testified earlier this year that the firm's problems were caused by trading by its London-based Financial Products unit in up to $2.77 trillion in unhedged credit default swaps.

In announcing plans to strengthen his bill by forcing most over the counter derivative activity by financial firms onto exchanges, Rep. Frank said that it would continue to provide commercial businesses flexibility in using the OTC market while diminishing the kind of speculative trades that led to AIG's downfall.

"It is in everybody's interest for as many of these as possible to be
traded on exchanges," Rep. Frank said. "To the extent that you increase trading
on exchanges, market forces are involved."

Last week, Gary Gensler, chairman of the U.S. Commodities Futures Trading Commission, testified that AIG's problems created by swaps trading highlight the reason those markets must be brought under federal regulatory control.

He called AIG "Exhibit A" of the failures of the financial system and the financial regulatory system last fall.

"AIG highlights the need for each of these four priorities. AIG was not required to meet capital standards or post margin for individual transactions," he said.

Moreover, "It was not subject to business conduct standards for its back office functions," he said. "AIG's failure was essentially a failure of a central counterparty in the sense that it internalized the credit risks of its trades," he added.

He said that "approximately $180 billion of our tax dollars went into AIG – that is nearly $414 million per each of your congressional districts," although AIG last week said that the amount it now owes the American people is $83 billion.

"While a year has passed and the system appears to have stabilized, we cannot relent in our mission to vigorously address weaknesses and gaps in our regulatory structure," Mr. Gensler said.

But Republicans on the committee disagreed. Rep. Scott Garrett, R-N.J., argued that placing more trades on
exchanges would do nothing to prevent the chance of another systemic-risk
collapse like AIG and could diminish the market because certain products
may not be conducive for exchange trading.

Rep. Jeb Hensarling, R-Texas, argued that derivatives overall were not the cause of the financial crisis. "Maybe derivatives didn't work in AIG's case, but a lot of firms were spared a fate that could be worse but that they used derivatives to limit their risk," he said.

In an amendment to the legislation firms would be designated as major swap participants if their activity would expose their counterparties to significant losses.

The legislation also provides authority to the Securities and Exchange Commission and the Commodity Futures Trading Commission to exempt firms from falling under the definition.

As passed by the Financial Services Committee, the bill mandates that all derivatives transactions, both standard and customized, be reported to a central trade repository. This is designed as a way of creating price transparency in what is often an opaque market, members of the committee were told.

It also would require the Commodity Futures Trading Commission and Securities and Exchange Commission to accept foreign regulations if they are comparable to U.S. regulation. It also would require that both counterparties on a particular trade to report it to either the SEC or the CFTC.