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Reforming financial markets

After months of hearings, the reform and oversight of financial markets remains on the Senate Agriculture Committee’s agenda.

Committee members are burdened with trying to achieve the right balance between pro-reform forces, large banking institutions bucking against change and some end-users claiming they’ll be forced out of speculative markets altogether if some legislative proposals are adopted.

At the outset of a Nov. 18 hearing Arkansas Sen. Blanche Lincoln, committee chairman, said the focus would be “on three areas: end-user margin and clearing, the definition of major swap participants, and mandatory clearing of standardized products.

“I particularly look forward to today’s testimony from end-users. Knowing the importance of cash flow and working capital to businesses, I will be paying as much attention to what they say about clearing requirements and margin as I will to how we address systemic risk.”

The first witness was Gary Gensler, chairman of the CFTC (Commodity Futures Trading Commission).

“I would like to address much-needed regulatory reform of OTC derivatives in the context of two principal goals: promoting transparency of the markets and lowering risk to the American public,” said Gensler.


In terms of transparency, the Obama administration “proposed, and I fully support,” the following priorities:

• All standardized derivatives transactions should be moved onto regulated exchanges or transparent trade execution facilities similar to securities or futures markets.

“Increasing transparency for the standardized derivatives should enable both large and small end-users to obtain better pricing on their derivative products.”

• All non-cleared — “customized transactions which should still be allowed” — should be reported to a trade repository for regulators to see.

• Data on the transactions themselves should be made available to the public in an aggregate form for both the customized and standardized product.

• Stringent recordkeeping and reporting requirements should be required for the swap dealers with an audit trail so regulators can effectively look into these markets even after the fact.


Further, said Gensler, to lower risk to the American public, “the administration proposed — and the CFTC supports — four essential components of reform.” Those are:

• Standard over-the-counter (OTC) derivative transactions should be required to be cleared on a robustly regulated central clearinghouse.

“Clearing significantly reduces systemic risk. … I believe that all clearable transactions should be brought into clearinghouses regardless of the end-user. But if Congress were to decide to exempt transactions for certain end-users I hope it will be narrowed to corporate end-users and wouldn’t exempt, for example, hedge funds and other financial investment funds. There’s a difference in the needs for those.”

• Swap dealers and major swap participants would be explicitly regulated for capital so there is a cushion against risk.

• Dealers (not the end-users) would be required to post margin themselves.

• The CFTC and SEC (Securities and Exchange Commission) should be authorized to mandate robust business conduct standards to protect the marketplace against fraud, manipulation and even aggregate position limits for commodities.


The CFTC “has been working with the SEC to harmonize some of our roles. We’re different agencies with different missions. But we have a lot of overlap. We’ve put together a report the president requested with 20 recommendations. Eleven will require legislative assistance.”

Gensler highlighted two.

“One, I believe that with the significant risk in these clearinghouses — futures and new swap — that is appropriate to look back to CFTC’s oversight of clearinghouses and bring core principles that have worked well … and assure that, in certain circumstances, the CFTC has a bit more authority to write rules.

“Second, we’ve found our ability to enforce the markets and protect them against manipulation can be enhanced. We have legislative language we’ll share with this committee on specific disruptive trading practices we think (need to have) enhanced policing.”


Lincoln asked Gensler who should make the determination about what’s standardized: the clearinghouse or the regulator?

“I believe the regulators — the SEC and CFTC — should have clear authority to determine that contracts are standard enough to be cleared. I also believe we should be able to rely on market mechanisms, that there’s some presumption that if a clearinghouse accepts it for clearing that we should be able to, hopefully, rely on that.”

Lincoln: “Are you comfortable with the Treasury (Department’s) definition of ‘major swap participants’?”

The CFTC is working to ensure there are two complementary regimes, said Gensler. “That the dealers are regulated — that the registered and regulated have business and capital conduct — and that the markets have the clearing and trading requirement.

“Major swap participant is a term that nine months ago none of us knew. It was created in the legislative language. What it’s really trying to address is the next AIG, or the wheeler-dealer, something that isn’t quite a financial institution but holds itself out to the public as a substantial net swaps business. There are many counterparties that would be at risk if it failed.

“It’s a broad category. It’s not meant to pick off the thousands of end-user or even the hundreds of end-users.”

CFTC expansion

In order for expanded market oversight to occur, the CFTC will need to be expanded, pointed out Georgia Sen. Saxby Chambliss, ranking member. The Congressional Budget Office “indicated the House legislation (for more, see House bill tightens market oversight) would require an additional 235 employees by 2011 for CFTC. That’s a 40 percent increase resulting in increased costs of over $291 million over the next five years. Your agency’s total appropriation for fiscal 2009 was only $146 million. How will you implement these changes set forth in the House bill, for example, if you don’t get the necessary increases in appropriations?”

Gensler said the CFTC has been “sorely under-resourced” for years. Only now is the CFTC “back to the same staffing we were at in 1999 even though the markets have grown at least four-fold and we’ve not yet taken on this new authority, if Congress asks us to (watch over) what is nearly a $300 trillion market.

“The swaps market is, roughly, 20 times our economy. That means every time you buy a ($50) tank of gas, you can think of about $1,000 of derivatives behind it.

“For staffing, we believe we’ll need 235 people to add on. 2010 staffing levels would be up to about 650 people.”

Many end-users of derivatives have informed the committee “they don’t believe the benefit of clearing is worth the expense of posting margin at a clearinghouse,” said Chambliss. “You’ve proposed clearing members of a clearinghouse, such as financial institutions, could post margins to the clearinghouse for their end-user counterparties who would then meet collateral requirements through credit arrangements involving non-cash collateral.”

Gensler was asked to help “think through this with regard to daily margin settlement. What sort of expense would end-users incur in the form of fees or variations margin charges if their dealers, as you propose, are posting margins to the clearinghouse on their behalf?”

The goal, said Gensler, is to “lower risk in the system and move as much of these transactions off the books of the financial institutions, once they’ve arranged them. That’s where the clearinghouse comes into play because that’s safer than the financial institutions.

“No matter what we do in financial reform, financial institutions will still, I believe, be very large, complex and have risk. That’s their business.”

Transactions should move to the clearinghouse “and allow end-users, just as they do now, to have individual credit arrangements — secured or unsecured — with banks and have the banks move them to the clearinghouse and post the margin. Today, they are charged a credit arrangement — these swaps do have a credit fee in them.”

End-user concerns

End-users have raised concerns, continued Gensler, echoing a point he made earlier in testimony “that it might still raise the cost. … I recognize that Congress might decide to exempt them. I hope any exemption is narrowed to the corporate end-users, not the financial end-users that do have liquidity and could post margins.”

Chambliss: “One practical aspect of that I have a problem with is, for example, Delta Airlines — a big user of this type of transaction — having to put up an airplane for each transaction. Or, any other company taking part of their non-cash collateral they’d normally post for a line of credit and (use) it as collateral for one of these type transactions. I’m not sure how we resolve that.”

Currently, many large institutions corporations — “and I’m not familiar enough with Delta’s finances” said Gensler — have credit arrangements “where they deal with large Wall Street firms saying, ‘if we hedge a transaction and an exposure develops six months or a year later, there is an arrangement.’ They may not secure with an airplane but they are, in some way, being charged with that credit arrangement. Even today, there isn’t a free lunch there.”

Chambliss then asked Gensler for his beliefs regarding trades on foreign markets. What about “the ability of foreign markets to give you the right kind of information and the receptiveness of foreign regulators on providing information to U.S. regulators, both SEC and CFTC?”

Gensler said the foreign markets would provide solid information. “I think the crisis was so severe in Europe, the United States and Asia that we do have a good consensus. (The Europeans) — and I’ve been over there and talk to their regulators almost on a weekly basis — put out a paper about a month ago. They say they’ll be mandating the standardized contracts be brought into transparent trading venues, just as we’re considering here. They’ll be mandating the standard contracts be brought into central clearing.”

The Europeans have also said that “for non-standard contracts they’d require banks to hold higher capital. They actually used the words ‘significantly higher capital.’”

This will be taken to the European parliament next summer. In the meantime, “they’re really watching closely what the Senate and House do here. But I’m optimistic that, though, different cultures and different political systems, we’ll come out about the same. Between Europe and the United States, that’s over 80 percent of these markets. And I think Canada, Mexico and Japan are likely to work with us, as well.”

Michigan Sen. Debbie Stabenow also worried over foreign trades. “One of my concerns is that without an international regulatory regime for energy commodity futures and derivatives trading and so on, we’ll see companies that use derivatives to hedge legitimate business risks be placed at a competitive disadvantage. … What else do you need from us … to ensure there’s an international agreement for our businesses?”

Gensler again expressed optimism. When President Obama “met with about 20 heads of state in Pittsburgh about two months ago, he was successful in negotiating these core principles right in the G-20 statement. (That was) to ensure we brought the standard parts of the market onto clearing and trading venues. It was at that high of a level at the G-20. Then, the European Commission followed up…

“It is important in the statutory language you pass there be some recognition of that, some explicit authority for the CFTC to register some foreign boards of trade.”


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