Treasury Official Says Municipalities Will Be Protected From Counterparty Risks

WASHINGTON — Though legislation that cleared the House Financial Services Committee yesterday would allow any municipality to participate in a derivative transaction as long as its counterparty is regulated, a high-level Treasury Department official said municipalities are still protected because those regulated parties will have to meet comprehensive business-conduct standards.

Michael Barr, Treasury’s assistant secretary for financial institutions, made the remark after being asked about a provision of the bill — which the committee approved mostly along party lines by a 43-26 vote — that defines eligible contract participants for derivatives as they pertain to state and local governments.

The provision, which mostly mirrors existing language in the Commodity Exchange Act, would qualify any municipality as an eligible contract participant as long as its counterparty is a regulated entity, including an insurance company, a financial holding company, or an investment bank.

Alternatively, the municipality would be considered an eligible contract participant if it has at least $50 million in “discretionary investments,” an increase from the $25 million threshold currently in the CEA. But this threshold does not apply if municipality’s counterparty is a regulated entity.

“One of the important steps that the bill takes is to ensure comprehensive business conduct regulation of all dealers in the system,” Barr said, speaking on a conference call with reporters. “So both with the requirement with respect to qualified participants and with comprehensive business conduct regulations of dealers, I think we have a strong investor-protection regime in this marketplace.”

He added that “regulated parties are going to need to be carefully watched with respect to the kind of transactions that they engage in with all counterparties, including municipalities.”

Barr hailed passage of the bill, which he repeatedly called “tough, strong and comprehensive.”

The bill will now have to be merged with a similar measure still pending before the House Agriculture Committee, before it is voted on by the full House, possibly as early as next month.

While Barr said he hopes Congress will adopt “a complete package” by the end of the year, the Senate is not expected to act on legislation until next year.

Rep. Colin Peterson, D-Minn., chairman of the House Agriculture Committee, said yesterday that he has tentatively scheduled a markup of his panel’s OTC derivatives bill for the middle of next week.

Yesterday’s vote on the Financial Services Committee bill comes as Securities and Exchange Commission chairman Mary Schapiro and other SEC officials had pushed the committee to toughen its bill to restrict small, unsophisticated municipalities from participating in the OTC derivatives market.

A bill introduced Sept. 22 by Sen. Jack Reed, D-R.I., chairman of the Senate Banking securities subcommittee, would go further than the House legislation by defining as eligible contract participants only those state and local governments with $50 million or less of discretionary investments. The provision would essentially prohibit governments from participating in derivatives transactions because it would force them to be done over exchanges.

The Reed bill also would not allow a government to count its bond proceeds in determining whether it meets or exceeds the $50 million threshold.

Commenting on the bill, Schapiro said: “This is a very important step forward in bringing these complex financial products under the regulatory umbrella and bringing transparency to this unregulated market.”

The Financial Services Committee bill included several major amendments, the most controversial of which would require a clearable derivative between financial institutions to be traded over a transparent exchange or electronic platform. That amendment, which was introduced by committee chairman Barney Frank, D-Mass., during debate on the bill, is opposed by Republicans and industry groups.

As initially drafted, the legislation would have given financial institutions the option of trading their derivatives on exchanges or complying with Commodity Futures Trading Commission record keeping and daily reporting requirements.

“Mandating particular transaction modes, as this bill does, could raise transaction costs while not necessarily reducing risk in a commensurate amount — results that we believe are contrary to our shared reform goals,” said Ken Bentsen, executive vice president for public policy and advocacy at the Securities Industry and Financial Market Association. “As the legislative process continues we look forward to working with the Congress toward a bill that strikes a balance between the need for transparency and risk-management efficiency.”

More generally, all standardized swap transaction between dealers and large market participants, or “major swap participants,” would have to be centrally cleared and traded on an exchange or electronic platform.

A major swap participant is defined as any entity that maintains a “substantial net position” in swaps, except those designed for hedging for commercial risk, or whose positions create such significant exposure to others that they require monitoring, according to a statement released by the committee.

However, transactions in standardized swaps that involve so-called end-users — entities that typically do not resell swaps, including municipalities — are not required to be cleared. Customized transactions would have to be reported to a trade repository.

The legislation sets out parallel regulatory frameworks for the regulation of swaps markets, dealers and major swap participants. Rulemaking authority is held jointly by the CFTC, which has jurisdiction over swaps, and the SEC, which has jurisdiction over security-based swaps, which would be defined as those swaps that are based on a narrow index of securities.

The Treasury Department would be given authority to issue final rules if the CFTC and SEC cannot decide on a joint approach within 180 days.

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