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Derivatives Bill Amended To Let Big Banks Keep Some Contracts Secret

First Posted: 03/18/10 06:12 AM ET Updated: 05/25/11 03:25 PM ET

Wall Street

The House Agriculture Committee approved legislation Wednesday beefing up regulation of the kind of opaque derivatives many blame for causing the financial crisis, but while proponents celebrate, critics say the bill exempts some transactions involving the very institutions -- big banks -- most responsible for the collapse.

Over-the-counter (OTC) derivatives -- essentially privately-negotiated derivatives contracts -- aren't traded on exchanges nor do they pass through clearinghouses. These contracts, which can act either as insurance (to transfer risk) or as a simple bet (like what many say brought down AIG), have been blamed for accelerating what was a credit crisis into a full-blown financial crisis and subsequent recession. They brought down the likes of AIG and the Wall Street investment houses Bear Stearns and Lehman Brothers.

There's been a big push by Democrats in Congress, reform advocates and the Obama administration to bring federal regulation to these deals. At the very least, advocates wants these contracts to go through clearinghouses or be traded on exchanges in order to make their terms public.

The Agriculture Committee's bill, shepherded by Chairman Collin Peterson (D-Minn.), does increase oversight of these previously mysterious and exotic financial instruments, experts say. Many derivatives trades would now have to go through clearinghouses or an exchange. But there are exemptions. In an effort to protect companies like airlines and manufacturers that use derivatives to hedge against things like price fluctuations and currency exchange rates, these so-called end-users would not be required to make public the terms of their contracts. Rather, they would continue to operate in the dark.

But Peterson on Wednesday amended the bill to extend the exemption to big banks and financial institutions, as long as their contracts were with these end-users.

Friday's bill said contracts are exempt from the new requirements if, among other things, none of the counterparties is a "Tier 1 financial holding company" -- essentially a big bank. Peterson's amendment this week eliminated that line.

So as long as a firm like Goldman Sachs enters into a contract with a company that's hedging against some kind of commercial risk (like rising oil prices), the terms of that contract don't have to be publicly disclosed.

Peterson's amendment "fatally weakens the bill," said Barbara Roper, director of investor protection at the Consumer Federation of America.

"[Peterson's] amendment now provides a broad exemption for contracts where one party to the contract is using the derivative to 'manage risk.' Mandatory central clearing is the basic reform that is essential to eliminate the potential for the failure of a single institution - such as Lehman Brothers or AIG - to bring down the entire financial system," Roper said in a statement.

During Wednesday's debate of the bill, Bloomberg News reported that Peterson said that the "target for greater regulation and oversight is not the end-user but their swap dealer or major swap participant counterparty. End-users did not get a bailout of billions of dollars. End-users are not responsible for what happened in markets last year."

Peterson's spokespersons did not immediately return repeated calls for comment.

In a Wednesday speech, the chairman of the Commodity Futures Trading Commission (CFTC) -- the federal agency that regulates derivatives -- said that banks should not benefit from the exemption.

"If Congress decides to exempt end-users from a clearing requirement, that exception should be very narrowly defined to include only nonfinancial entities that use swaps as an incidental part of their business to hedge actual commercial risks," CFTC Chairman Gary Gensler said. "I do not believe that hedge funds, financial firms or other investment funds should be exempted from a clearing requirement."

The Obama administration said much the same thing in its proposed bill that it sent up to Capitol Hill. Before Wednesday's debate, Peterson himself criticized efforts by big banks to evade further regulation of their derivatives activity.

"If it were up to me, a bill to regulate these markets would have been signed into law a long time ago," Peterson said in opening remarks. "However, large banks have a long history of using their financial and political advantage to try to gum up and slow down reform efforts by sowing discord between members and Committees."

That seems to be exactly what happened with Peterson's amendment.

"With Wall Street pulling out the stops to gut the bill, Congress appears all too willing to renege on the promise it made when it called on American taxpayers to bail out the big banks: that in return it would adopt the comprehensive reform that was needed to prevent a recurrence," Roper said.

"After all we have been through, mandatory central clearing of standardized derivatives should be a given. In the immediate wake of the market's collapse, it looked as though the only debate would be over whether we would also get mandatory exchange trading of standardized contracts (a must for meaningful price competition) and how big the exemption for customized contracts would be," she continued.

The Treasury Department declined to comment.

"Now, we are back to square one, the big banks are back in the driver's seat, and the prospects for meaningful reform grow dimmer every day," Roper said.

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