OTC Derivative Reform Clears 1st Hurdle In House

By Jessica Dye

Law360, New York (October 15, 2009) -- The U.S. House of Representatives' Financial Services Committee voted Thursday to approve a landmark bill designed to introduce new regulation and transparency to the over-the-counter derivatives market, a key provision of the Obama administration's financial reform agenda.

Representatives voted 43 to 26 in favor of the Over-the-Counter Derivatives Market Act, which gives the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission joint authority over the OTC market, puts capital and margin requirements on derivatives traders and compels firms to process derivative products through approved clearinghouses, to mitigate the threat of risky trades.

On Wednesday, Financial Services Chairman Barney Frank, D-Mass., abruptly changed the stance taken in draft legislation and introduced an amendment to the House bill that echoed the Obama administration's OTC regulatory proposal by requiring some OTC swaps to be made on exchanges or electronic platforms.

The amendment — adopted by a vote of 39 to 25 on Thursday morning — has been a sticking point for regulators, who claimed that allowing swaps to happen off the more visible exchange platforms would do nothing to increase officials' ability to monitor the trades.

Derivatives traders have shot back that forcing OTC swaps through exchanges would drive up trading prices and discourage investors from entering those markets.

Frank's compromise amendment would exclude the majority of traders by providing exemptions for small businesses and traders looking solely to hedge commercial risks by derivatives trading. It would also give the SEC permission to exempt institutions dabbling in financial derivatives trading, if the majority of their OTC swaps are done for risk management purposes.

In a final round of votes marking up the bill Thursday morning, committee members rejected a Republican counterproposal to the bill — which would have nixed the SEC and the CFTC's proposed OTC oversight duties and made margin and capital requirements far more flexible — but did include an amendment that would cap ownership in clearinghouses and OTC swap execution facilities at 20 percent, in order to limit conflicts of interest among derivative traders and vetters.

The Financial Services bill is one of three currently in the House that proposes a new oversight regime for OTC derivatives, a favorite scapegoat of the economic meltdown, particularly in connection with failures at American International Group Inc.

The U.S. Department of the Treasury has also sent draft legislative language, and a separate version is currently being considered in the House Agriculture Committee.

Focus will now shift on the Agriculture Committee's bill, a draft of which was unveiled earlier in October. It hews closely to the Treasury and the Financial Services Committee's language, but does include foreign exchange swaps under the scope of the bill's definition of “swap,” unlike the other two bills.

The Agriculture Committee's bill would also divvy up jurisdiction of swaps, using a preponderance test to give the CFTC primary authority over swap-related provisions and the SEC authority over security-based swap provisions, instead of dividing jurisdiction equally among the SEC and CFTC.

Work is expected to begin on the Agriculture Committee's version of the bill in the next few weeks. If passed, it must be reconciled with the Financial Services legislation before heading before the full House for a vote.

Frank said Thursday that he hoped to have a bill ready for the president's signature by the end of the year.

The House has already passed one piece of the financial regulatory reform package the Obama administration has requested from Congress — a provision limiting executive compensation.

The Financial Services Committee will now take up work on another part, which proposes the creation of a consumer financial protection agency to monitor products such as credit cards.

Committee members on Thursday approved by a voice vote an amendment to the CFPA offered by Reps. Brad Miller, D-N.C., and Dennis Moore, D-Kansas, that would exempt banks with assets less than $10 billion and credit unions holding less than $1.5 billion from the bill's examination requirements.

A final vote on the committee's controversial CFPA proposal has been delayed until next week, Frank said.

The delay on CFPA action has also forced Frank to push back scheduled hearings on legislation related to regulating systemic risk, but he pledged that the postponement would put the systemic risk bill off track by no more than a week.

--Additional reporting by Evan Weinberger