U.S. bill would restrict OTC derivatives holdings

July 30, 2009

USA/ By Charles Abbott and Rachelle Younglai
WASHINGTON, July 30 (Reuters) – U.S. financial regulators would gain the power to restrict holdings of over-the-counter derivatives under legislation to be crafted in the coming months, the chairmen of two House of Representatives committees said on Thursday.

Barney Frank of the Financial Services Committee and Collin Peterson, of the Agriculture Committee, said anti-speculation provisions would be part of legislation to bring the $450 trillion OTC derivatives market under federal regulation.

The bill would also clamps down on a type of derivative called credit default swaps (CDS), which have been blamed for magnifying global economic distress by spreading losses from bets on risky mortgages and other debt.

The swaps are used to insure against debt defaults and speculate on borrower’s credit quality.

A key question for the derivatives bill is whether to ban outright “naked” CDS, where the trader or investor does not hold the underlying asset being insured. An alternative is requiring regulators to monitor CDS trading and restrict the size of holdings — position limits — by dealers and large investors.

“We will have in the bill, I believe, full authority to SEC and CFTC to impose limits, both overall position limits and (trading) time outs,” said Frank, referring to the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The SEC polices stock markets and the CFTC oversees futures markets. The agencies would split the workload of handling OTC derivatives under the legislative outline by Frank and Peterson.

Frank said his committee would begin work on the bill after the August recess and he hoped for a floor vote this year. Peterson said his committee probably would hold its own drafting session to add some provisions.

At a news conference, to outline their principles for legislation, the chairmen said they agreed for the most part on how to regulate the derivatives market. Frank said there were no “deal breakers” among the remaining issues.

Their plan calls for OTC derivatives to go through regulated clearinghouses in most cases. By sharing risk, clearinghouses assure payment of transactions and bring liquidity into markets. They also set margin and reserve requirements for transactions.

Regulators would develop margin and capital requirements that would create a “strong incentive” for dealers and users to trade them on exchanges or other electronic platforms or have them cleared whenever possible.

“At this point there is an incentive not to standardize because you can make more money that way,” Frank told reporters after the news conference.

The administration has already proposed requiring all so-called standardized derivatives to be cleared by a clearinghouse.

That has worried derivative dealers and those that use derivatives to hedge against price fluctuations. Derivatives users fear that they will no longer be able to customize contracts to suit their needs. The largest dealers stand to lose profits if more of the contracts become standardized.

The administration has yet to provide a definition of a
standardized contract and Frank said most of that will be left up to the SEC and CFTC.

“If I am one of the end users, I would probably get a better price on an exchange than if I made some face to face deal,” Frank said.

Derivatives users would also be allowed to use noncash collateral to satisfy margin requirements — a provision Frank said was “totally in response to the end users.”

“You don’t want to disadvantage people from going on exchanges. That is very much at the request of industrial and energy end users.”
(Reporting by Charles Abbott and Rachelle Younglai; Editing by Tim Dobbyn)

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