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Groups: OTC Regulation Bills Would Hurt Swaps

Two industry groups warned yesterday that a draft bill that would regulate over-the-counter derivatives would hurt interest rate swaps and destroy the credit default swap market. Meanwhile, a group representing state lawmakers called for CDS broker-dealers to be regulated like monoline bond insurers.

The groups made their remarks at a hearing held by the House Agriculture Committee on the draft bill, which was circulated last week by chairman Collin C. Peterson, D-Minn.

The draft, which is similar to a bill introduced in January by Sen. Tom Harkin, D-Iowa., would give the Commodity Futures Trading Commission the authority to regulate over-the-counter derivatives, including interest rate swaps and credit default swaps. It would require the CFTC to impose detailed reporting requirements and would require OTC derivatives to be settled and cleared through a CFTC-regulated designated clearing organization.

In the case of financial derivatives, the CFTC could permit an OTC derivatives transaction to be settled and cleared through an SEC-regulated clear agency or a Federal Reserve-regulated central counterparty.

At the hearing, representatives from the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association said the draft bill would seriously diminish OTC derivatives transactions and would destroy the CDS market along with jobs and tax revenues derived from it.

The use of interest rate swaps has grown in the municipal market in recent years and represents billions of dollars, though no specific estimates are available. The muni credit default swap market is estimated to be about $250 billion, a mere sliver of the $58 trillion corporate CDS market.

Robert Pickel, chief executive officer of ISDA, said the draft rule would allow the CFTC to order otherwise regulated institutions such as banks and broker-dealers to terminate privately negotiated contracts in some cases.

"This seems to represent an unwarranted intrusion into the jurisdiction of other federal regulators," he warned. It also would "undermine legal ... certainty" and "make it difficult for parties to calculate how much capital to hold against such contracts."

Pickel added that the draft bill "would likely cause a significant decrease in OTC activity."

He also said that "while clearing should be encouraged ... mandating clearing of all OTC derivatives is unwarranted."

Edward J. Rosen, a partner at Cleary Gottlieb Steen and Hamilton LLP who testified on behalf of SIFMA, called the proposed mandate for clearing all OTC derivatives "impractical and unnecessary." He said that not all OTC derivatives can be cleared on an exchange and that clearing houses might not be able to price or provide collateral requirements for certain OTC derivatives.

Rosen said the prohibition of "naked" CDS protection "would essentially eliminate the corporate CDS market" and "would exacerbate the current credit crisis."

But Joseph D. Morelle, a New York state assemblyman who spoke on behalf of the National Conference of Insurance Legislators, said states should regulate CDS broker-dealers like monoline bond insurers.

Morelle called speculative CDS trades "gaming" and said such trades "offer nothing of value to the real economy." He said state regulators with jurisdiction over monoline insurers should have the authority to require CDS broker-dealers to post collateral for hedging CDS transactions.

"In many ways this [regulation] mirrors the work we do with bond insurers," he said.

Morelle said that under state law, insurance companies file a derivatives use plan with regulators. The plan requires insurance companies to use derivatives "as a hedge as opposed to a speculative opportunity," he said. If the requirement extended to all CDS broker-dealers, then it would end speculative CDS positions.

Altogether, 23 witnesses testified on the draft legislation during two days of hearings.

Meanwhile, Gary Gensler, President Obama's pick to lead the CFTC, told Sen. Carl Levin, D-Mich., that he will work with Congress to provide greater OTC derivative transparency.

In a series of questions and answers released by Levin's office this week, Gensler said that he believes OTC derivatives need to be cleared through an exchange. The move would "enhance the safety and soundness of the system by requiring timely posting of collateral," he told Levin.

Gensler said that while at the Treasury Department during the late 1990s, he advocated for regulation of OTC dealers. "I feel even more strongly that this is the right course of action today," he said.

Asked about a merger between the CFTC and the Securities and Exchange Commission, Gensler said it "makes sense only if it enhances our ability to carry out the important tasks with which the CFTC is entrusted. Thus I would not consider a merger simply for merger's sake."

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