U.S. finance reform bill may ban ‘naked’ credit default swaps

July 21, 2009

U.S. Rep. Collin Peterson WASHINGTON, July 21 (Reuters) – An omnibus financial reform bill in the U.S. House of Representatives would require that over-the-counter derivatives go through clearinghouses and probably ban “naked” credit default swaps, the chairman of the House Agriculture Committee said on Tuesday.
Collin Peterson said he and Financial Services Committee Chairman Barney Frank were in agreement on steps for a bill that would be the product of their panels. They share oversight of futures and equities markets.
“We will have one big bill this fall,” Peterson told reporters.
The over-the-counter derivatives market, which has a global notional value of $450 trillion, is now largely unregulated. The market includes credit default swaps (CDS), the financial instruments blamed for spreading the risks of bad mortgages in the financial crisis, often with high leverage.
A naked credit default swap is a CDS for which a trader or investor does not hold the underlying asset being insured, such as a bond.
The House Financial Services Committee was scheduled to begin drafting a financial reform bill later this week.
The Agriculture Committee passed a bill in mid-February that requires clearing of OTC derivatives and strengthening of U.S. anti-speculation rules. The two bills will be merged, said Peterson.
He said the reform will would spell out jurisdictional boundaries of the Securities and Exchange Commission and the Commodities Future Trading Commission over OTC derivatives and create a coordinating council to resolve any disputes over which agency would regulate a derivative.
“We’re gong to have the same rules in both agencies,” said Peterson, to assure equality of regulation.
While he and Frank agree on mandatory clearing, Peterson said, the administration prefers a proposal that standardized OTC derivatives must go through clearing while customized contracts would be allowed. They would be subject to rules on reporting and capitalization.
Peterson said the administration approach left too much leeway for oversight.
“Barney and I are going to have mandatory clearing,” said Peterson. Under that approach, all contracts would go to central counterparties. If a clearinghouse rejected a contract as being specialized, the SEC or CFTC would set the margin and collateral requirements for it.
“I imagine SEC and CFTC will set higher margins” and reserves, said Peterson.
The Agriculture Committee bill passed in February would allow the CFTC to suspend trading of “naked” credit default swaps (CDS). The reform bill would go a step farther, said Peterson — “We’ll probably ban naked credit default swaps.”
A ban on speculative CDS trading could drive investors away from the CDS market and shrink its volume, said John Jay, senior analyst at Aite group in Boston.
Joel Telpner, a partner at the New York law firm of Mayer Brown, said it would be difficult to shoe-horn all OTC derivatives through clearinghouses. Some contracts are so specialized in their terms, they will not be suitable for clearing, he said.
“As long as you have regulation and comparable capital requirements for derivatives that aren’t centrally cleared they shouldn’t be a systemic risk,” he said.

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