When Congress returns from its Easter recess next week, efforts to bring rules and oversight to unregulated parts of the derivatives markets will resume with fresh energy.
Sen. Tom Harkin, D-Iowa, the chairman of the Senate Agriculture Committee, has pledged to enact stricter requirements on derivatives trading than those already approved by the House Agriculture Committee.
And though there remain many broad questions to answer, such as which congressional committees claim jurisdiction and how oversight of those instruments will be structured, the crux of the debate is whether to ban over-the-counter derivatives contracts.
"I see no other feasible way to achieve these critical objectives than to require trading of all derivatives on regulated exchanges," Harkin told American Banker this month. "I am focused on enacting a comprehensive bill that will restore transparency, integrity, accountability and public confidence in these markets."
Harkin's quest to require all derivatives to be traded over exchanges would effectively ban OTC trading, which uses highly specialized contracts that are drawn up for individual counterparties and are seldom, if ever, replicated. The specificity of these OTC contracts prevents them from being brought onto a central clearing platform, which does not involve the instantaneous trading of an exchange, but simply records the trades and requires counterparties to post capital to the clearing party instead of to one another.
Central clearing requires a certain level of standardization among contracts; without it, the contracts could not be properly recorded and evaluated for collateral needs by the central clearing party. Exchange trading, meanwhile, requires an even higher level of standardization — to a degree that would allow the contracts to be traded as equal units.
Some market participants and regulators think a law like Harkin's would be too harsh, and a similar effort to ban all OTC trades died in the House. "Previous drafts of the bill required all derivatives to be cleared and then the end result was what was most politically possible," said a spokesman for the House agriculture committee. He said that committee Chairman Colin Peterson, D-Minn., decided to back away from banning all OTC trades and instead carve out exceptions that would allow certain types of OTC contracts to continue to be created.
A spokesman for Harkin said the senator does not agree, and plans to proceed with his push for an OTC ban.
Regulators still see a role for customized contracts.
"We think as much as possible OTC derivatives contracts should be cleared through a central clearing party," said Kathryn Dick, the deputy comptroller for credit and market risk. However, that "doesn't mean that it has to be 100% standardized."
Dick said there would have to be exceptions for contracts that were too specifically tailored to their trading parties to be cleared.
"If you require that all contracts be cleared, then you would probably constrain novel products," she said. "This could limit your ability to develop new products."
Gathering more information on credit derivatives — most notably credit-default swaps — will help stabilize the financial system, regulators argue. For example, more information about who is writing CDS contracts that insure against a corporate default will reduce the level of anxiety created by changes in the price and volume of those trades.
Over half of the roughly $20 trillion worth of CDS contracts today can be cleared. Only the largest U.S. banks trade CDS contracts, but other, smaller banks use derivatives like currency forwards and interest rate swaps. There is little public information on exactly which banks use which derivatives, but the OCC is requiring all banks with assets over $10 billion to provide more information about their derivatives counterparties and collateral.
Despite Harkin's strong position, his legislation faces high hurdles and may not do much good without international cooperation.
"There are very significant jurisdictional issues, because it's a global phenomenon and market, not a national market," said Kip Weissman, a partner at Luse Gorman Pomerenk & Schick.