Two powerful House committee chairmen vowed to collaborate Friday on moving legislation that would substantially increase the regulation of the more than $590 trillion over-the-counter derivatives market, putting aside any jurisdictional differences over the issue.

“Clearly we will be significantly expanding the regulation of derivatives,” House Financial Services Committee Chairman Barney Frank, D-Mass., said at a joint hearing with the Agriculture Committee.

Frank’s counterpart on the Agriculture panel, Minnesota Democrat Collin C. Peterson, also signaled his support for bringing the market under new regulation, saying “I believe that solving this mess regarding unregulated swaps and derivatives is an effort that must pass Congress and be signed into law.”

The two brushed aside any suggestion of jurisdictional infighting.

“We may not agree on everything,” Peterson noted, but added: “we have expressed a willingness to work together to pass strong, comprehensive, and consistent regulation of over-the-counter derivatives.”

“By the time we are through with the collaboration of these two committees, we will substantially increase the authority of regulators to deal with these things,” Frank said.

House Republicans, though, were wary of plans to expand regulation of derivatives. “We must be careful not to overreach,” Frank Lucas of Oklahoma, the ranking GOP member of the Agriculture panel, said.

“Derivatives do serve a valued place in the marketplace when used with judgment,  . . .  they provide legitimate means” for managing risk, Lucas said.

Administration Plans

As part of its broad financial overhaul plans, the Obama administration has proposed new oversight for derivatives, including requirements that “standardized” contracts be cleared through regulated exchanges.

A derivative is a financial instrument whose value is based on an underlying asset, such as a Treasury bond or commodity like oil or copper. Companies use derivatives to hedge against various business risks, including changes in interest rates, commodities prices and the cost of raw materials.

While derivatives have become a prominent part of Wall Street’s business, they are also used by farmers to manage risk, primarily through futures contracts.

Explosive growth in the financial derivatives market over the last decade meant some companies were able to run up huge, and sometimes risky, exposures in derivatives markets without significant regulatory oversight. When the economic downturn hit, some of those companies, most notably insurance giant American International Group Inc., were unable to meet billions of dollars worth of derivative obligations.

AIG became heavily involved in a derivative known as a credit default swap, basically insurance that a loan or other form of debt will be repaid.

Standard vs. Custom Derivative

The administration has yet to fully flesh out several specifics of its plan, including the precise distinction between what constitutes a standardized derivative contract versus a “customized” one. The latter, which generally describes a specific deal made between two parties, would not be subject to as strict regulation under the plan.

In testimony before the two committees, Treasury Secretary Timothy F. Geithner reiterated the administration’s commitment to forcing standardized derivatives contracts to be cleared through regulated exchanges, adding that he wants those new rules to be “difficult to evade” so companies couldn’t use “spurious” customization to avoid an exchange.

But Scott Garrett, R-N.J., worried that a clearinghouse could end up stifling the market.

“Mandating the use of central clearinghouses for derivatives contracts has the potential to restrict liquidity in the marketplace, limit the ability of businesses to hedge their unique risk and tie up capital that could be used to promote business development,” he said in a statement.

Geithner offered a few details of how the administration would distinguish between standardized and more propriety custom derivatives.

“We will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardized,” Geithner said.

Other criteria for evaluating whether a derivative is standardized would include the volume of trades in the derivative and “the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared.”

For customized derivatives contracts, the administration plan would subject participating companies to new oversight, including “conservative” capital and margin requirements.

Peterson asked Geithner whether he expected those distinctions to be spelled out in the law or left up to regulators.

The secretary said he hadn’t made a final decision, but he expected to “lay out broad principles in statute and have them defined with more clarity in regulation.”
Geithner said it would make sense “to put higher capital requirements on the customized products to avoid” the risk that companies would avoid clearinghouses by declaring their derivatives custom.

Regulated Exchanges

Some lawmakers, including Senate Agriculture Committee Chairman Tom Harkin, D-Iowa, have advocated requiring all over-the-counter derivatives to be traded on regulated exchanges.
Business groups are sure to resist such a move.

“Transparency and strengthening oversight of the derivatives markets by promoting central clearing is important to reducing risk to the system,” said Ryan McKee, senior director of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce. “However, requiring all over-the-counter derivatives contracts to be centrally cleared will limit the ability of businesses across the country to tailor risk protection to their individual needs. We want to make sure that we achieve the right balance so that we do not prevent businesses from efficiently managing risk in the first place.”

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