US push on derivatives market reform comes clearer

July 28, 2009

By Kevin DrU.S. Representative Barney Frankawbaugh
WASHINGTON, July 27 (Reuters) – The shape of the U.S. government’s proposed crackdown on the $450-trillion over-the-counter derivatives market became clearer on Monday, with Congress poised to move forward this week on other aspects of a sweeping overhaul of U.S. financial regulation.

In a draft reform bill obtained by Reuters, House of Representatives Democrats called for new curbs on one of the most volatile segments of OTC derivatives trading — the $39 trillion market for credit default swaps (CDS).

The draft bill would let regulators set limits on CDS dealers, while also possibly banning so-called naked CDS, the most speculative segment of a ferociously turbulent market.

The Obama administration is expected to release its own proposed legislative language for OTC derivatives on Thursday, said sources familiar with the administration’s thinking.

Taming the OTC derivatives market — a “shadow banking system” of enormous size NOW largely beyond government reach — is a key part of a push for tighter government oversight of banks and capital markets under way now for six months.

Policymakers have been urging stronger OTC derivatives oversight ever since former insurance giant American International Group Inc nearly collapsed in 2008 under the weight of bad CDS bets. AIG was bailed out by taxpayers at huge expense.

Credit default swaps are over-the-counter contracts between two counterparties that bet on whether a company will default on its bonds within a fixed period of time.

Naked CDS are used to make speculative bets rather than hedge on real debt holdings.

Many more months of debate lie ahead as Washington tries to fashion a policy response to the worst financial crisis in generations, brought on in part by the government’s failure to regulate OTC derivatives, critics say.

Congress is close to acting on another issue — finding a way to rein in sky-high corporate executive compensation.

The House Financial Services Committee is slated to hold a session on Tuesday to draft and likely vote on legislation that would give shareholders a louder voice in setting executive pay, while barring excessive compensation at financial firms.

On Monday, White House spokesman Robert Gibbs, commenting on a report that a top Citigroup Inc <C.N> trader is pressing the bank for a 2009 pay package that could total $100 million, said “that’s probably a bit out of whack on any pay scale.”

Representative Barney Frank, chairman of the financial services committee, said shareholders must set the outer limits of executive pay since boards of directors are not up to it.

Speaking to the National Press Club on Monday, Frank said Congress can complete regulatory reform before year’s end.

“We invite the financial community to participate with us given what we believe is necessary and how we do it, but it’s going to happen one way or the other,” Frank said.

Those who balk at reform will be outside the debate and are inviting harsher treatment, he cautioned.

His comments came as the Securities and Exchange Commission finalized two interim rules to clamp down on a form of abusive short selling known as naked short selling and give regulators more information on big investors’ short positions.

Short sellers borrow shares they consider overvalued in hopes of repaying the loan by buying back the shares for less and pocketing the difference. A naked short sale occurs when an investor sells stock that has not yet been borrowed.

The SEC also announced that it is examining “flash” stock orders involving exchanges and trading systems that disseminate information to select market participants, potentially disadvantaging others.

Frank also said that banks in nations that offer an “escape hatch” to stricter financial regulations should be barred from the U.S. payment system.

“If the secretary of treasury cannot certify that you are cooperative with regulation, then none of your banks can be in the American payment system, none of them can get cleared through the Federal Reserve,” he said.

* FACTBOX-Draft bill to tighten U.S. OTC derivatives rules
* CFTC set to tackle position limits, exemptions
* FACTBOX-US works to expand CFTC role, commods oversight
* Seven firms face Aug. 13 deadline on pay plans

For a copy of the draft Democratic legislation, click here

(Additional reporting by Rachelle Younglai, Chuck Abbott; Editing by Leslie Adler)

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