Legislation designed to limit federal scrutiny of derivatives trading may wind up doing just the opposite.
The bill, introduced by Senate Agriculture Committee Chairman Richard G. Lugar, R-Ind., would limit the Commodity Futures Trading Commission's jurisdiction to regulated exchanges and retail futures contracts. Privately negotiated over-the-counter and certain exchange-traded derivatives used by large banks and other institutional investors would be exempted from the commission's oversight.
But a six-page list of modifications to the Lugar bill prepared by agriculture panel aides has banks and other derivatives dealers worried that the bill may end up slapping them with more-not less-regulation. The committee employees suggested expanding the commission's oversight to include certain over-the-counter foreign currency and government securities transactions.
The document also suggested watering down a provision that would set up "professional markets," exchanges in which sophisticated derivatives dealers would face lighter regulation.
At an American Enterprise Institute panel discussion last week, several investment bankers argued against any additional regulation. "This is a marketplace which is best regulated by direct participants in the marketplace," said John P. Davidson 3d, principal at Morgan Stanley & Co.
"The Lugar bill began as a very workable, much-needed project, but it is clearly getting worse for the private sector," added Mark C. Brickell, a managing director at J.P. Morgan & Co. "The way businesses succeed is by meeting the needs of clients quickly and at the lowest cost."
Privately negotiated contracts-those that are custom-tailored between two parties and designed to hedge specific risks-are big business for banks. At the end of the first quarter, 504 commercial banks held $18.6 trillion of these over-the-counter derivatives.
In recent years, the over-the-counter market has grown to 86% of notional bank derivatives holdings; exchange-traded contracts made up only 14% of bank holdings at March 31.
"CFTC is somewhat frustrated that they don't have control over this part of the market," said Heinz Binggeli, president of Global Investment and Risk Advisors, a risk management firm on Long Island, N.Y. "They are fighting for territory."
Extending the commission's oversight to over-the-counter contracts would be bad news, derivatives dealers complained, largely because dealing with the commission can be excruciatingly slow.
"If a client calls our swap desk and asks to hedge risk in wood pulp products, we may need less than a day," Mr. Brickell said. But a futures exchange could take as long as a year to create a new commission-regulated contract, he said. Some bank regulators have sided with the industry. In February, Federal Reserve Board Chairman Alan Greenspan argued that commission oversight is not necessary for a private market that has done a good job policing itself.
Actual losses to institutional counterparties in the United States from dealer defaults have been small, Mr. Greenspan said, mainly because bankers and other buyers of derivatives work only with dealers who have good reputations and credit ratings.
He added that dealers in off-exchange derivative contracts limit their risk by settling them in cash, basing prices on highly liquid markets, and limiting penalties to the actual damages suffered.
An agriculture panel aide said lawmakers are mulling the staff recommendations. Once they reach an agreement, the bill will be voted on by the committee but probably no earlier than September, the aide said.
