The Treasury Department's draft derivatives bill contains a technical glitch that renders meaningless a provision that was intended to restrict small municipalities from participating in derivatives transactions, several lawyers said late last week.

The draft legislation would amend the section of the Commodity Exchange Act that defines what constitutes an "eligible contract participant" for a derivatives transaction.

The Treasury intended its proposed amended version of the provision to mean that governments or political subdivisions that own and invest less than $50 million in discretionary investments would not be eligible contract participants for derivatives transactions.

"The legislation would tighten the definition of eligible investors that are able to engage in [over-the-counter] derivatives transactions to better protect individuals and small municipalities," the Treasury said when it released the draft.

The idea was that if a government is already investing $50 million of its own funds, it should be sophisticated enough to participate in derivatives transactions.

However, the draft bill erred in not proposing to amend the rest of that section of the CEA, which cross-references another section of the act that essentially says that any government can be considered an eligible contract participant for a derivatives transaction as long as its counterparty is a bank or other financial institution, a broker-dealer, bank or broker-dealer holding companies, or an insurance company. That list of firms represents all of the potential kinds of counterparties in muni market derivatives transactions.

In other words, one of the lawyers said, a government could be "as poor as a church mouse" and have no investable assets, but could still be an eligible contract participant for a derivatives transaction as long as its counterparty was a bank, broker dealer, holding company or insurance company.

Muni market participants had focused on that provision of the administration's draft derivatives bill to try to determine which governments would be barred from the derivatives business.

Several of them had pointed out that the provision would only be directed at governments, not private borrowers in conduit deals. They also had said that "discretionary investments" would mean funds the government invested itself or through another party.

However, unless the provision is reworked, it would not limit any municipalities from engaging in derivatives transactions, they said.

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