New commodities regulations should not preclude hedges, Geithner says

Over-the-counter derivative regulatory reforms should not jeopardize businesses’ efforts to manage financial risk, US Treasury Secretary Timothy F. Geithner said on July 10.

Over-the-counter derivative regulatory reforms should not jeopardize businesses’ efforts to manage financial risk, US Treasury Secretary Timothy F. Geithner said on July 10.

“We want to preserve their capacity to participate in bilateral transactions as hedges as we increase overall protection for investors,” he told a joint hearing of the US House Agriculture and Financial Services Committees.

A key consideration will be whether a hedge is a standardized contract on a regulated exchange or electronic trading system, or a customized bilateral agreement, Geithner said. The Obama administration does not want to make customized derivatives illegal, but it would like them to be much less appealing to investors than standardized contracts, he indicated as he outlined the administration’s broad initial reform proposals.

“The lack of transparency in the OTC derivative markets, combined with insufficient regulatory policing powers in those markets, left our financial system more vulnerable to fraud and potentially to market manipulation,” he told the two committees.

“These problems were not the sole or the principal cause of the crisis, but they contributed to the crisis in important ways. They need to be addressed as part of comprehensive reform, and they cannot be adequately addressed within the present legislative or regulatory framework,” Geithner maintained.

Members of Congress have charged that financial speculators used unregulated financial instruments to push crude oil prices to record levels by mid-2008. Some have introduced bills which would require all trades to occur on regulated exchanges. Independent oil and gas producers and others who use commodity hedges have said that excessive regulation could hurt them financially.

Backed by assets

Rep. Bill Cassidy (R-La.), an Agriculture Committee member, said that utilities in his district have told him they need hedges to help keep consumers’ bills from climbing, and that they back their commitments with their assets. He asked Geithner how such deals would be defined under the proposed new regulations.

“I’ve received several letters about this, and I’m sure you have too,” Geithner replied. “We will need to look at this closely, but we intend to preserve the option for their use.”

He said that the Obama administration’s broad objectives are to keep OTC derivative activities from posing risks to the broader financial system’s stability; to promote efficiency and transparency in OTC derivative markets; to prevent market manipulation, fraud, and other abuses; and to protect consumers and investors by making sure that OTC derivatives are not marketed inappropriately to unsophisticated parties.

To that end, Geithner said that the administration would like all standardized derivative contracts cleared through well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trading systems. It proposes encouraging substantially greater use of standardized contracts through capital requirements and other measures so that more OTC derivatives migrate to central clearinghouses and regulated exchanges. It also wants to require all OTC derivative dealers and other major market participants to be subject to substantial supervision and regulation, including conservative capital requirements.

The administration’s proposals also include steps designed to make OTC derivative markets more transparent. It would do this by having the US Commodity Futures Trading Commission and the Securities and Exchange Commission impose recordkeeping and reporting requirements, including an audit trail, on all OTC derivatives. “We will require that all OTC derivatives that are not centrally cleared be reported to a regulated trade repository on a timely basis,” Geithner said.

He said that the administration also would like to see Congress give the CFTC and SEC “clear authority for civil enforcement and regulation of fraud, market manipulation, and other abuses in the OTC derivative markets.” It also intends to work with the two agencies to tighten standards for participating in OTC derivative markets, and continue to work with other governments to ensure that they match this strict and comprehensive regulatory regime, he said.

Defining contracts

Geithner said that the definition of a standardized contract under the proposed regulations would be broad, would be capable of evolving with the markets, and would be difficult to evade. “We will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardized. Further attributes will include a high volume of transactions in the contract and the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared,” he explained.

“We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges,” the Treasury secretary continued. “In addition, we will raise capital and margin requirements for counterparties to all customized and non-centrally cleared OTC derivatives. Given their higher levels of risk, capital requirements for derivative contracts that are not centrally cleared must be set substantially about those for contracts that are centrally cleared.”

Committee members asked what steps could be taken to assure full international cooperation so contracts don’t simply move to significantly less regulated overseas venues. “Oil has driven the calls to reform how we regulate these markets, but it’s globally traded,” said Rep. David Scott (D-Ga.), a member of both committees.

Geithner said that he approved of CFTC Chairman Gary G. Gensler’s July 7 announcement that he would hold a hearing to establish federal limits on energy commodity speculation and consider whether various market participants should be exempt. “It’s clearly an effort to begin to address price volatility issues, but I believe more steps need to be taken to make markets more transparent,” he said.

He also conceded that there’s a risk that some countries might not want to match new, tougher US regulations of OTC derivatives. The administration is working closely with governments in Europe and Asia to coordinate reforms, Geithner said. “We’re trying to do something that’s never been done, to move together so that trading doesn’t move abroad, so we’re trying to involve all global financial centers,” he said.

Financial Services Committee Chairman Barney Frank (D-Mass.) suggested that legislation authorizing reforms could contain a provision allowing bilateral sanctions against any country which clearly tries to attract commodity trading business with looser regulations. He and Agriculture Committee Chairman Collin C. Peterson (D-Minn.) said that work on actual legislation probably won’t begin until September, but that a hearing was needed now to discuss initial proposals and air concerns.

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