October 15, 2009
The Gibson, Dunn & Crutcher Financial Markets Crisis Group is closely tracking government responses to the turmoil that has catalyzed a dramatic and rapid reshaping of our capital and credit markets. We are providing updates on key regulatory and legislative issues, as well as information on legal and oversight issues that we believe could prove useful as firms and other entities navigate these challenging times.
This update focuses on the House Financial Services Committee’s consideration of Chairman Frank’s (D-MA) legislation, the Over-the-Counter Derivatives Markets Act of 2009, which the Committee marked up yesterday and ordered reported today.
Over-the-counter (OTC) derivatives products, little discussed by policymakers before last Fall, became a lightning rod for the financial regulatory reform debate as a result of the financial markets crisis. Derivatives have been vilified by several members of Congress and have been identified as causes of the crisis. Business end-users of OTC derivatives have been working to educate members on the importance and legitimacy of derivatives products in terms of managing risk. The debate is now coming to a head in the House as one committee ordered legislation reported today and another is expected to take up a competing bill next week.
Complicating the reform effort, derivatives are regulated by both the Securities and Exchange Commission and the Commodities Futures Trading Commission and fall primarily under the jurisdiction of two different House and Senate committees. The Senate Committee on Banking, Housing, and Urban Development and the House Financial Services Committee have jurisdiction over the SEC, and the Senate and House Agriculture Committees have jurisdiction over the CFTC. Moreover, certain aspects of derivatives reform implicate bankruptcy provisions, drawing the Senate and House Judiciary Committees into the debate.
Up to this point, reform efforts have moved slowly. Last Spring, House Agriculture Committee Chair Collin Peterson (D-MN) marked up his committee’s first attempt at derivatives regulatory reform. This Summer, the Administration sent its version to the Hill. Finally, this October, House Financial Services Chairman Frank produced his draft of derivatives reform, and, shortly thereafter, a Manager’s Amendment. On October 9th, Chairman Peterson released new draft legislation that is scheduled to be marked up by the House Agriculture Committee on Thursday, October 22.
Over-the-Counter Derivatives Markets Act of 2009
On Wednesday, October 15, the House Financial Services Committee held a mark-up of Chairman Frank’s Over-the-Counter Derivatives Markets Act of 2009 and then ordered it reported this morning by a party-line vote, with the exception of Representative Jones (R-NC), who voted with the Democrats. The bill would amend the Commodity Exchange Act and the Securities Exchange Act of 1934 to regulate swap markets and swap market participants. Significantly, it would bring transactions between "Swap Dealers" and "Major Swap Participants" onto centralized clearing, increase disclosure, margin, and capital requirements, and reduce participation in the OTC market.
Prior to the mark-up, the Coalition for Derivatives End-Users recommended several changes to Chairman Frank’s discussion draft "in order to ensure that companies can continue to access customized, OTC derivatives." The recommendations included the following:
The grandfathering and exemptive authority amendments were adopted, though the latter took a slightly different form. The margining amendment was defeated this morning.
Key aspects of the legislation and debate include: (1) clearing and exchange trading; (2) the definition of "Major Swap Participant"; (3) margining and capital requirements; (4) future bailouts; and (5) the grandfathering of existing contracts.
The text below recounts how these issues were addressed during the mark-up.
1. Clearing and Exchange Trading
To provide increased transparency and stability, legislators have called for derivative contracts to be cleared and settled through central clearing parties (CCPs), to be traded on exchanges like securities, or both. The Committee adopted Chairman Frank‘s Manager’s Amendment that would create a clearing requirement for swaps (as defined in the bill) that are accepted by a derivatives clearing organization and are between Swap Dealers or Major Swap Participants. The underlying bill ceded to the CFTC and SEC the responsibility for determining what swap contracts would have to be cleared, based upon a number of factors. The amendment places a large burden on end users who only engage in derivatives trading to hedge their own risk and do not pose a systemic risk to submit an application for exemption from the clearing requirement.
Representative Garrett (R-NJ) argued that this proposal goes "180 degrees" in the opposite direction from Chairman Frank’s original proposal, which Representative Garrett had commended last week. Though he supports encouraging exchange trading, Representative Garrett argued that the Manager’s Amendment would eliminate the utility of customized derivatives because though the end-users would be exempted from exchange trading, there would be no available counter-party to enter the contract.
Ranking Member Bachus (R-AL) asserted that Chairman Frank’s amendment would price out small companies. He also suggested that the amendment would increase systemic risk because exchanges will attract less sophisticated investors.
Representative Minnick (D-ID), however, supported the amendment, noting that because there would be more than one exchange and more than one swap execution facility, there would be competition to reduce transaction costs. Representative Watt (D-NC) also supported the amendment as a compromise between the Administration’s proposal and the original Frank proposal.
The Committee adopted Chairman Frank’s Manager’s Amendment by a vote of 39-25.
2. Major Swap Participants
Last week, CFTC Chair Gary Gensler and the Director of the SEC’s newly established Division of Risk, Strategy, and Financial Innovation, Henry Hu, noted that Chairman Frank’s draft bill inadvertently would allow hedge funds and government sponsored enterprises, including Fannie Mae and Freddie Mac, to avoid regulation under the derivatives bill. Chairman Frank, along with Representatives Minnick and Watt, offered an amendment to redefine "Major Swap Participant" to close the loophole. The new definition will bring large traders of derivatives, including hedge funds and GSEs, under the legislation’s regulatory authority. It also creates some degree of uncertainty as to whether business end users that do not pose systemic risk could be captured by the revised definition.
Responding to a question from Representative Capito (R-WV), Chairman Frank clarified that the size of a business does not matter for purposes of the regulation. Instead, traders with a "substantial net position" would be affected, regardless of their size.
The Committee adopted the amendment by voice vote.
3. Margining and Capital Requirements
To protect counterparties against default, all derivatives proposals would impose new margining and capital requirements, or give the SEC and CFTC increased authority to do so. While the requirements would lend stability to the economic system, they also would remove capital from the markets. Several end-users have testified that high margining and capital requirements will cause them to forego planned projects that would create jobs and increase production capacity in the United States.
The Committee considered Representatives Garrett and Jenkins’ amendment to insert language that the SEC and CFTC may not impose margining requirements if one party to a transaction is not a Swap Dealer or Major Swap Participant. Representative Jenkins (R-KS) argued that the amendment is necessary to protect end users. This amendment was recommended by the Coalition for Derivatives End-Users.
The Committee defeated the amendment by a roll call vote.
4. Future Bailouts
Representative Sherman (D-CA) offered and then withdrew an amendment to prevent bailouts from being available under resolution authority or under derivatives laws. Chairman Frank acknowledged that bailouts are an important issue and that the Committee would address them when discussing the more general legislation on systemic risk.
Ranking Member Bachus then offered Representative Sherman’s amendment again, arguing that there may not be a chance to address bailouts at a later time. Chairman Frank stated that substantively, he agrees with the amendment, but as a point of order, the amendment was non-germane on its face because it prohibited bailouts under "any other act." Ranking Member Bachus offered the amendment again without the language regarding "any other act," limiting the prohibition to bailouts under the derivatives language.
The Committee adopted the amendment by voice vote.
Representative Sherman likely will introduce a broader amendment during the debate on systemic risk regulation. During hearings, he has been a vocal opponent of bailouts and has pressured Treasury and Federal Reserve officials to impose limits on bailout authority.
5. Grandfathering of Existing Contracts
Many market participants have been concerned that their existing contracts will be altered by any new regulation that would be enacted. Representative Lee offered an amendment to exclude pre-existing trades from central clearing, capital, and margin requirements, as well as to exclude pre-existing securities-based trades from incremental capital and margin requirements. He argued that the amendment would prevent contracts from being exposed to unanticipated alterations during the worst possible economic time. This amendment was developed by the Coalition for Derivatives End-Users
The Committee adopted the amendment by voice vote.
Now that the House Financial Services Committee is set to report a bill, the next step is for the House Agriculture Committee to mark-up and report its own measure. Then, committee and House leadership will have to resolve differences between the two measures and produce a bill that can be taken to the House floor. Whether that process can be completed before the end of the current Congressional session — likely some time around the holidays — is unclear. What is clear is that a bill regulating OTC derivatives is unlikely to reach the President’s desk before 2010.
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