A Funny Thing Happened On The Way To The Forum: Update On The OTC Derivative Reform

As I have mentioned in past blogs, the last bill to be proposed on OTC derivative reform was to be issued by Senator Blanche Lincoln (D-Ark), Chairman of the Senate Agriculture Committee, who also has jurisdiction over the CFTC. Today, Senator Lincoln finally issued her bill in a bold move with some surprising changes.

Up until a week ago, word on Capitol Hill was that she was going to come out with a fairly moderate bill with no major differences to what we have seen from the House or from Dodd’s bill with the Senate Banking Committee. However, with the advantage of going last, she has been able to address some of the concerns of both hard line democrats and regulators, while keeping the spirit of end-user exemptions, but with one major impact. In a surprise move, this bill eliminated the Fx Forward and Fx Swap exemption, which was in all of the other bills. With the inclusion of these instruments, Swap Dealers, Major Swap Participants and Banks would be required to trade them on exchanges if available or clear them, which in both cases would require the associated additional capital charges and margining costs. Real time data repositories would also have to report on them, which given their high volume of transactions, could prove to be challenging and costly.

Although end-users can still enjoy the benefits of not being forced to exchange trade, clear or post margin against those trades, it was better to have these instruments exempted outright, as I fear the dealer costs mentioned above will be passed on to end-users.

But it is important to take note that, for end-users, she has done what no other bill has done, which is to actually define what an end-user is and to more clearly articulate what end-users will be exempted from, whether that means being required to exchange trade or clear contracts even if Swap Dealers, Major Swap Participants and Banks are required to do so. Clearly defining the end-user is a suggestion I made to the Committee last year in my testimony. With a clear end-user definition in the legislative language, potential loopholes that could put the financial system at risk can be appropriately addressed without the unintended consequences of crippling the legitimate hedging activities of businesses.

On this positive note, Senator Lincoln is providing better clarity and demonstrating that she understands some of the root causes of the financial crisis. For example, the definition of Major Swap Participant (MSP) has caused angst with some who have felt that they could be erroneously included in this category. In her legislative language, she clarifies the definition of an MSP as one that could cause risk to the financial system of the US—for example, banks that are highly leveraged. Other bills had no mention of leverage, the true root cause of the crisis, and focused too much on single counterparty risk as opposed to systemic risk. In addition, the CFTC is named specifically as the one to define what a substantial net position is, which makes sense since it is best equipped to determine this for MSPs who won’t be regulated by the Fed or other Prudential Regulator.

So no doubt Swap Dealers and banks are not too thrilled as there is stronger language on exchange trading, clearing, capital and margining requirements. It could also become illegal to bail out banks that end up in trouble because of their derivative activity.

It will be interesting to see in the week ahead how Senator Lincoln’s own Committee will vote on the bill and whether she will have enough Republican support to prevent a filibuster in the Senate. My guess is that she will have it, given the renewed attention on fraud from the SEC’s recent charges against Goldman Sachs.