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Derivatives Reform Weakened By Two Little-Noticed Amendments

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Two little-noticed amendments inserted Wednesday into legislation seeking to strengthen regulation of derivatives will allow private industry to continue to set rules and largely self-regulate, tying the hands of regulators who want more say in how these exotic financial instruments are traded.

Offered by Rep. Judy Biggert, an Illinois Republican, the provisions take away power the Obama administration proposed giving to the Commodity Futures Trading Commission (CFTC), the regulator in charge of policing most types of derivatives. Rather, the power to supervise how derivatives are traded will rest with the clearinghouses and exchanges that house them. Furthermore, when the exchanges and clearinghouses change or offer up new rules, the CFTC will not be able to review them before they are finalized to ensure, for example, that they comply with existing law. Instead, the rules proposed by private industry will immediately go into effect.

These powers, which the CFTC has lacked since a major deregulatory law was passed in the waning days of President Bill Clinton's final term, would enable the CFTC to exert the kind of authority many have criticized the agency for not using. Unregulated derivatives trading by the likes of AIG and Lehman Brothers nearly caused the collapse of the global financial system.

Biggert's amendments were quickly adopted by the House Financial Services Committee without debate. Committee Chairman Barney Frank, who has repeatedly promised meaningful reform, punted the issue to the House Agriculture Committee which is handling a separate yet similar bill. Derivatives reform legislation passed Financial Services on Thursday morning. Biggert was not available for comment. A spokesman for Frank said the issues the provisions addressed should be handled by the agriculture committee, and that Biggert's amendments "were accepted to move the debate along."

"It's a return to the regulatory environment that led us into the meltdown," said Michael Greenberger, a professor at the University of Maryland Law School and former director of trading and markets at the CFTC. "It would tie the hands of effective regulation by the CFTC to the detriment of economic recovery. The [Obama] administration had it completely right in its proposal."

The day Obama announced the administration's plan, Biggert put out a news release calling the proposals "too light on reform."

A senior official at the CFTC said the agency was dismayed by the committee's adoption of Biggert's amendments, whose home district encompasses some Chicago suburbs. The Chicago Mercantile Exchange is a major derivatives exchange. The official did not wish to be identified, citing the commission's efforts to work with the committee in enacting reform.

As it stands, the CFTC cannot tell exchanges or clearinghouses how to police the derivatives market. Unlike the Securities and Exchange Commission, which sets rules governing the securities market, the CFTC can only issue non-binding suggestions, which don't have to be followed. It's an important difference. For example, the CFTC cannot enact a rule mandating that a clearing house have enough capital to cover it in case its biggest member defaults on its obligations.

When AIG couldn't cover its obligations after its risky derivatives blew up, U.S. taxpayers stepped in. Goldman Sachs reaped $12.9 billion from its position as a counterparty to some of AIG's deals.

In a July interview on MSNBC, Frank was adamant that derivatives regulation would undergo major overhaul.

"What we're going to say is this: first of all, the rule will be -- we're going to repeal an act that was done in 2000. Senator Phil Gramm took the lead. It was during the Enron crisis. And legislation was adopted that shielded these derivatives from much regulation. That was a cause of great stress in the economy. It exacerbated some of the problems.

We are going to restore to the SEC and the CFTC according to their jurisdictions power to regulate derivatives. We will specifically be requiring that, in almost every case, derivatives go on an exchange, that they not be these -- or a clearinghouse -- that there not be these individualized deals. And if people are going to make individualized deals, they're going to have to have a lot more capital behind it.

"So you're going to see a very tough set of regulations that will empower the SEC and the CFTC to stop much of the problem that we've had today."

CFTC's lack of power in this area can be traced back to the Commodity Futures Modernization Act in 2000. That bill, pushed by former Senator Phil Gramm (R-Tex.), whose wife once headed the agency, deregulated derivatives trading and officially sanctioned what had been until then the legally murky world of over-the-counter (OTC) derivatives, which are privately-negotiated derivatives contracts (other types of derivatives are traded on exchanges or pass through clearinghouses).

According to Greenberger:

"When the act essentially deregulated the over-the-counter derivatives market, the exchanges were not happy about that, because essentially it was sanctioning what they deemed at the time to be a major competitor. The law before the act was passed said that everything had to be traded on an exchange unless they received a special exemption... But when Congress went to say, 'Okay, we're going to sanction this otherwise questionable-on-a-legal-basis market, the exchanges said, 'Well, what about us? What are you going to give us?'

What they gave them was the ability to post contracts and create rules that had previously needed to be approved by the CFTC before they went into effect to allowing them to go into effect immediately. [Congress gave] the CFTC the power to block [the contracts and rules] if the CFTC could show, by substantial evidence, that they violated the law. That power has never been used by the CFTC."

The Obama plan would give the agency 10 days to review proposed rules, and an additional 90 days beyond that if the agency needed more time for review. Biggert called the proposed review time "burdensome," and, in a reference to the pre-2000 agency, she said it "prevented exchanges from moving innovative products to the market quickly."

The administration's plan also would have given the agency the ability to formulate specific rules, like those employed by the SEC to ban manipulative and anti-market practices. As the administration's white paper on regulatory reform noted, the agency takes a "principles-based approach" in its supervision and enforcement, while the SEC employs a "rules-based approach." The plan would have allowed the CFTC to specify what meets its "principles." Right now, that's entirely up to private industry -- and the CFTC has zero say in the matter.

"Giving the CFTC a meaningful chance to demonstrate that a rule would do harm to the financial markets, and the economy as a whole, is absolutely imperative," Greenberger says.

That hands-off approach to financial regulation has been used in the United Kingdom for more than a decade. But it's come under fire since the onset of the financial crisis.

"It's proved to be totally ineffective," Greenberger says. "The Bush administration was insistent that things be principles based. In other words, you have general prescriptions that don't have enough specificity to them that you can ever understand whether an action violates the principle."

The UK's financial regulator now refers to its regulatory philosophy as "outcomes-focused regulation."

While derivatives fall under the House Financial Services Committee, they also fall under the House Agriculture Committee. That's because derivatives were originally futures contracts for agricultural goods, like wheat, that farmers used to hedge against risk.

So now both committees have offered competing bills to regulate derivatives. Thus far, though, the version in the agriculture committee still has the Obama proposals. But the bill has yet to be marked up in committee. The committee's chairman, Collin Peterson (D-Minn.), hasn't shown signs that he's all that interested in enacting tougher regulations.

In April, Peterson compared the ease of doing business with the CFTC to the SEC.

"You talk to people that have had dealings with both of them and everyone of them will tell you what a delight it is to work with the CFTC compared to the SEC. It takes years to get anything done in the SEC. They are all focused on did you fill this paper out right. It's all kind of legalese ... where the CFTC is more market-oriented or principle-based or whatever."

The agriculture committee is expected to take up its version next week.

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