Not Just Wall Street Opposes CFTC Derivatives Overhaul
Industry groups backed by Koch Industries Inc. and Cargill Inc. are fighting a Senate bill that would reshape almost 30 years of policy that allowed the $605 trillion over-the-counter derivatives market to surge and helped trigger the financial crisis in 2008.
Legislation introduced by Senator Christopher Dodd, a Connecticut Democrat, would give the Commodity Futures Trading Commission authority over most of the U.S. market, the broadest expansion of its authority since becoming an independent agency in 1974.
“The devil is in the details, but if passed, it could be monumental,” said Tom LaSala, chief regulatory officer for CME Group Inc.’s New York Mercantile Exchange, in an interview this week.
The Dodd bill would give the commission the power to monitor over-the-counter trading, impose heightened capital requirements on companies with large swaps positions and limit the number of contracts a single trader can hold. The bill, which is expected to be taken up by the Senate this month, would push standardized swaps onto regulated exchanges or similar electronic systems.
“I don’t think anyone would disagree that with this bill, they will get a lot more power,” said Mark Young, a partner with the law firm Kirkland & Ellis in Washington. “If the Senate passes the bill, it will be a substantial change in the regulatory policy and direction.”
At stake is control of one of Wall Street’s most lucrative businesses. Trading revenue in unregulated markets last year generated an estimated $28 billion for five U.S. dealers including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley, according to company reports collected by the Federal Reserve and people familiar with banks’ income sources.
Jamie Dimon, JPMorgan’s chief executive officer, told analysts yesterday that derivatives legislation could reduce the bank’s trading revenue by “several hundred million dollars to a couple billion dollars,” depending on the details.
The over-the-counter derivatives market has escaped the commission’s reach since the first interest rate swap was traded in 1981. The transactions fell outside a law requiring that all futures be traded on regulated exchanges. Before swaps came along, risk-management trading outside of the exchanges was generally restricted to “forwards,” or bilateral trades that provided for physical delivery between commercial parties, such as a farmer and a grain elevator.
Three decades later, the U.S. over-the-counter market has grown to $300 trillion and remains unregulated “in stark contrast with the other major parts of our financial markets,” CFTC Chairman Gary Gensler said in an April 12 speech at Columbia University in New York. Derivatives were “at the center of the 2008 financial crisis.” The authority to monitor the industry will protect American taxpayers from another costly bailout, he said.
American International Group Inc., once the world’s largest insurer, received a bailout in September 2008 that swelled to $182.3 billion after losses on derivatives tied to home loans.
The company’s “ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system,” Gensler said.
Legislators are grappling with the “unintended consequences” of leaving those products largely unregulated, said Michael Frankfurter, trading manager of Cervino Capital Management LLC in Santa Barbara, California.
Losses tied to derivatives based on subprime mortgages were at the center of the collapse of AIG, Lehman Brothers Holdings Inc., Washington Mutual Inc. and other banks. The losses triggered a $700 billion taxpayer-funded bailout.
“They are trying to put the genie back in the bottle,” Frankfurter said in a telephone interview. “The problem is, politics being politics, everyone is looking for an asymmetrical advantage, which is how the world works.”
Since the beginning of 2009, large banks and financial firms have spent more than $500 million on campaign contributions and lobbying over a variety of issues, according to data from the Center for Responsive Politics.
A provision in the bill known as the “end-user exemption” is of particular concern to industry groups representing Koch, Lockheed Martin Corp. and Caterpillar Inc. The rule would exempt companies that use derivatives to hedge their risks in commodities, currencies and interest rates from posting margin, or a deposit against default, on over-the-counter trades.
Margin requirements would increase costs and cripple small businesses, said Paul Cicio, president of the Industrial Energy Consumers of America, whose group represents companies including Dow Corning Corp., The Goodyear Tire & Rubber Co. and Tyson Foods Inc.
“Many of my companies would have to put up $50 million to $100 million just for margin, and that ties up a lot of cash,” Cicio said.
The Dodd bill allows the commission to exempt transactions under three conditions: one party to the swap is deemed an end- user, the swap meets generally accepted accounting principles for hedging and the firm is not “predominantly” engaged in financial activities, said Cory Strupp, managing director of the Securities Industry and Financial Markets Association.
“It’s a carve-out for end-user activities but it’s not a complete carve-out, and it’s not mandatory,” Strupp said. “It just says regulators may exempt that transaction.”
The Natural Gas Supply Association and the National Corn Growers Association are writing a letter to Dodd and Senators Harry Reid and Richard Shelby saying the end-user exemption is too limited, according to a draft obtained by Bloomberg. The gas association conducted a study in December that concluded that requiring end-users to clear their derivatives transactions could cost the U.S. economy as much as $900 billion.
“Without such an exclusion, energy and commodity producers will be forced to divert capital that would have otherwise been invested in producing energy, food and thousands of jobs, while risk would be increased rather than decreased,” the trade groups say in the letter.
Legislation approved by the U.S. House of Representatives in December contained a more inclusive definition of end-user, said Jon Hixson, director of government relations with Cargill, a global exporter and processor of agricultural commodities.
“You need a clean exemption for manufacturers and exporters,” Hixson said.
Katie Stavinoha, a spokeswoman with Koch Supply & Trading LP, declined to comment.
The Coalition for Derivatives End-Users, which includes the U.S. Chamber of Commerce and the National Association of Manufacturers, supported the wider exemption in the House version of the legislation, said Dorothy Coleman, vice president of tax and domestic policy at the National Association of Manufacturers.
Gensler has testified that the House bill might allow speculators, including hedge funds, to qualify for exemptions. His concerns were echoed by Senator Blanche Lincoln, an Arkansas Democrat and chairwoman of the Senate Agriculture, Nutrition and Forestry Committee, in a letter April 13 to four of her Senate colleagues.
The exemption “could open up major loopholes that could be exploited to the detriment of our financial system,” Lincoln said in the letter.
“I will propose a narrow exemption for only those end users who are hedging legitimate commercial risk,” Lincoln said. “Speculators will not be exempted and all trades will be reported to regulators and the public.”
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