WASHINGTON — Regulators from the Commodity Futures Trading Commission and Securities and Exchange Commission urged House Democrats Wednesday to strengthen a bill designed to better regulate derivatives, arguing it was too weak and had several flaws.
Though Financial Services Committee Chairman Barney Frank acknowledged some of the criticisms at a hearing, saying he would make changes, he also said he was wary of at least one concern: a provision that would let end users, such as banks, enter in to derivatives contracts without first using a clearing house.
Industry representatives were pleased that Frank's draft of the bill, introduced last week, was less tough than an Obama administration discussion draft that would have given banks and others little leeway to avoid using a clearing house for derivatives hedged for risk. Such a mandate could substantially raise costs for derivatives end users and ultimately kill the market.
But Frank said market participants have the right to make a profit on derivatives. "It is clear we can't expect financial institutions to be available to help the end users as a charity," he said. "They need to make a profit, or they will not be available to provide that liquidity which is important. But that's the line we want to draw."
Still, Frank said some changes were due. "On the specific bill today, I agree with some of the criticisms that have been made," he said. "I acknowledge there are some areas here where there are gaps that shouldn't have been there."
CFTC Chairman Gary Gensler outlined several ways in which the legislation should be made tougher. "All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by [the] end [of] 2012 at the latest," said Gensler, reiterating the president's goal. "It's our challenge now — our challenge as administration and regulators and, hopefully, working with Congress — to achieve this goal."
He highlighted several disagreements with the Frank bill. Instead of allowing regulators to require the clearance of standard derivatives, lawmakers should mandate clearance, he said. He also faulted an exception that would let nonfinancial entities use swaps to hedge commercial risk without using a clearing house, saying it potentially would cover too many companies.
"We think, if there is an end-user exception that Congress believes we need to endorse, that it be very narrowly defined, as the chairman said, to address nonfinancial entities that use swaps to hedge actual commercial risk, as contrasted to financial entities," Gensler said.
He also said the discussion draft expands too much an intentionally narrow exception for major swap participants by carving out swaps entered into for risk management purposes.
Henry Hu, the SEC's director of the division of risk, strategy, and financial innovation, who also testified at the hearing, said Frank's bill left some holes in regulatory oversight. "The discussion draft is an important step forward in improving transparency and establishing the necessary regulatory framework," he said. "While it would go a long way toward improving the regulation of OTC derivatives, I believe it should be strengthened in several ways."
Frank said there is plenty of room to accommodate regulators' requests, and that he would change the bill to ensure there were no holes in regulatory oversight. But he said he did not want to mandate a requirement that end users clear standard derivatives.
"It is our intention to have a push in favor of clearing but a recognition that that won't always be possible," he said. "On the clearing requirements for end users, you recommend that they all go through a clearing house. I don't think you're going to see that happen because of the response that many will have to the end users."
Frank said the legislation's point is that it should distinguish between excessive speculation and legitimate hedging for risk by producers of services and end products. "Derivatives are a very legitimate way for producers of end products, goods or services, to reduce volatility," he said. "Our job is to find a way to preserve that legitimate function while diminishing the excessive volatility that comes from people who are doing it to speculate."