Opinion

The Great Debate

Industry defeated on U.S. derivatives reform

May 14, 2010

Senate Democrats have beaten back an ambitious, industry-supported amendment to the derivatives portion of financial reform legislation.

If passed it would have significantly weakened the administration’s efforts to tighten regulation of over the counter derivatives markets.

Yesterday’s vote went largely along party the lines (39-59). But Senate Democrats attracted support from moderate Republicans Olympia Snowe (Maine) and Charles Grassley (Iowa), making that part of the bill effectively filibuster proof.

So far lobbyists have largely failed to change the direction of the bill despite heavy pressure on members of the chamber to make it more industry-friendly.

It now looks like the final derivatives reform will be largely along the lines advocated by the White House and the U.S. Treasury Department, and that industry lobbying will not materially affect the outcome.

CHAMBLISS AMENDMENT
Yesterday’s crucial amendment offered by Senator Saxby Chambliss (R, Georgia) (Amdt 3816) was a second-degree amendment to the main one (Amdt 3739) already offered by Banking Committee Chairman Christopher Dodd and Agriculture Committee Chairman Blanche Lincoln, which is the chamber’s working text on financial reform.

Senate Rules permit amendments of amendments (“amendments in the second-degree”) but not amendments of amendments of amendments (third or higher degrees) except by unanimous consent.

So Dodd-Lincoln (Amdt 3739) is the “language to beat.” It is the text the Senate will finally vote on, except insofar as it is altered by the current welter of second-degree amendments being offered from the floor.

“Chambliss” would have substantially re-worked the derivatives language. It seems to have been the Republican caucus’s main effort to alter the legislation to meet industry objections.

It was co-sponsored by Senate Republican Leader Mitch McConnell, Shelby (the senior Republican on the Banking Committee) and Senator Judd Gregg (R, New Hampshire), who has criticised some efforts to force more regulation of over-the-counter markets as excessive, as well as nine other mostly conservative Republicans).

The aim of “Chambliss” was to modify aspects of the bill bodies representing derivative dealers found most objectionable. But it went down to heavy defeat after it failed to attract a single Democratic vote and lost support from Republicans Snowe and Grassley.

GUTTING THE BILL
If it had been approved, “Chambliss” would have changed several important aspects of the legislation in ways supported by most swap dealers but opposed by the White House, the U.S. Treasury Department and the Commodity Futures Trading Commission (CFTC):

(1) It would have exempted “swap end-users” from the requirement to clear derivative transactions through a recognised clearing house.

(2) The definition of “end user” would have been broadened to include exchange-traded funds, mutual funds and unit trusts (registered under the Investment Company Act 1940), and pension funds, as well corporations using swaps to hedge physical risks in a more traditional way.

(3) “Bona fide hedging swap transactions” would have been redefined. Not only traditional hedges by people who own, produce, manufacture, process, sell or buy commodities, but anyone who anticipates changes in commodity and other prices could have an impact on the value of their liabilities, or a potential change on the cost or value of goods and services they provide, purchase or anticipate providing or purchasing, would have qualified.
In fact, almost everyone, including pension funds, exchange-traded funds and retail investors.

(4) The combined impact of the end-user and the bona-fide hedging exemptions would have ensured almost everyone was covered. The only swaps subject to compulsory clearing would have been those executed between banks; even there the amendment provided careful loopholes.

(5) The CFTC’s authority to mandate clearing; require disclosure of aggregate data on volumes and prices for swaps not cleared; and impose minimum margin requirements would all have been significantly circumscribed.
In each case the bill would have required the Commission to rely on “economic analysis” supplied by the Commission’s chief economist, who may cite “peer-reviewed or other relevant literature conducted by independent researchers”, before exercising its rule-making powers in these areas.

In effect, this would have given the chief economist and other academic researchers chosen by him a veto over the Commission’s rule-making.

CFTC economic analysis has been cited with approval by some dealers — in particular the famous finding there is “no evidence” linking widespread increases in the price of oil and other commodities during 2004-2008 to speculation or an inflow of investment. But it remains controversial.

The commissioners have not repudiated those findings. But at least some members seem keen to press ahead with new rules anyway without waiting for fresh analysis by the staff. The Chambliss amendment would have created an (impossibly high) hurdle for new rule-making by the CFTC in several key areas of the bill.

(6) Aggregated position limits adopted by the Commission under its new powers would not apply to positions acquired “in good faith” prior to the enactment of the legislation, provided the holder does not attempt to increase them. In effect this grandfathers old positions.

(7) Numerous sections of the bill would have made it possible for the Commission to grant exemptions on margin, clearing, and position limits through a simplified “notice-and-comment” procedure while insisting it use a much more lengthy and tough rule-making process to impose them in the first place.

Exemptions would have been easy to give, rules hard to impose, tipping the bill’s balance against market regulation.

END GAME PLAYS OUT
The Chambliss amendment’s heavy defeat on the floor, and failure to find the crucial 40th vote needed to filibuster the final bill on passage, suggests the White House and Treasury will largely get to keep the derivatives reforms they have pressed for.

Senate Republicans are paying their dues to both Wall Street and U.S. business organisations, after a strong outreach programme earlier in the year, and will expect strong financial and political support from them in the current election cycle.

But the party’s internal unity on Chambliss was largely for show. On current trends it will not significantly alter the direction in which the derivatives section is evolving or prevent it passing into law largely unchanged in a couple of months time.

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