Legislation to regulate derivatives appeared to be on the fast track Thursday as two House committee chairman said they were close to a final agreement on a bill that would significantly curb trading of credit-default swaps and provide strong incentives for banks to bring contracts on to regulated exchanges.
The deal between House Financial Services Committee Chairman Barney Frank and Agriculture Committee Chairman Collin Peterson signals the bill is not likely to get tied up in a jurisdictional fight that could delay or scuttle it.
"We are very close," Frank said at a press conference. "None of the remaining areas" under discussion "are deal breakers."
The bill also attempts to find a middle ground between the Securities and Exchange Commission and the Commodity Futures Trading Commission by creating a special office inside the Treasury Department to resolve any future jurisdictional disputes.
While details remained vague, the panels released just a broad outline of the proposed legislation, the bill appears to be strict on banks in some cases.
The bill would put new limitations on who can enter into credit-default-swap contracts and under what circumstances. To purchase a CDS contract, a bank would either have to hold a stake or an economic interest in the asset underlying the contract or would have to be "a bona fide market maker."
Regulators would be able to ban certain entities from participating and impose position limits on CDS counterparties. They would also be able to ban certain types of contracts, though the outline of the bill does not specify whether bans could apply retroactively to outstanding contracts.
Industry participants have already expressed concerns over the legal uncertainty that could arise if regulators had a say over which kinds of over-the-counter derivatives contracts would be allowed in the future. Allowing them to ban contracts could also throw the validity of existing individual agreements into question.
Banking industry representatives are also raising concerns that such a plan could dramatically reduce the number of participants in trades, resulting in fewer contracts and a less liquid market.
"I'm sure the most active traders and dealers in this market are going to be fighting this pretty hard," said Brian Gardner, an analyst with Keefe, Bruyette & Woods. "There is a good argument to be made in principle that in the end it will have an effect on liquidity."
Bankers fear that the limitations will hurt institutions that engage in a CDS trade to hedge their risk because they find it more difficult to find a counterparty that is both willing and qualified to engage in a trade.
But Michael Greenberger, a professor at University of Maryland Law School, said the prohibitions appear more aimed at trades in which neither counterparty had an economic interest or stake in the underlying asset.
"This is designed to address naked credit-default swaps, where both counterparties aren't hedging," he said.
Greenberger said the proposal would not satisfy those advocating for the strictest version of OTC derivatives regulation. "Overall I see this as a major victory for the financial services sector," he said.
Scott DeFife, a lobbyist for the Securities Industry and Financial Markets Association, agreed the plan was not as tough as it could have been. An earlier push by Peterson would have made exchange-trading mandatory, a move that would essentially have banned all OTC derivatives.
Under the new plan, though OTC derivatives would not all be forced on to exchanges, they will be required to be cleared unless a regulator deems a certain contract too highly customized. DeFife said it was positive that lawmakers appear to be leaving such a definition to regulators rather than strictly defining a standardized contract.
"You want to leave more flexibility to the regulators to adapt to changing circumstances," he said.
Instead of defining standardization, lawmakers have chosen to set up incentives, including higher capital requirements and collateral requirements for customized trades that cannot be cleared or traded on an exchange.
"There's also market pressure," Frank said. "If I'm one of those end users, I'd probably get a better price on an exchange than if I made some face-to-face deal. Capital requirements drive a lot of it, because the higher your capital requirements, the more you're going to have to charge someone you're doing business with."
Since the attempt to regulate OTC derivatives began, banks have frequently complained that accounting rules prevent them from counting as hedge positions any contract that is not specifically aligned to unique risks on their balance sheets.
Frank said that while he did not want Congress to legislate accounting rule changes outright, he would write to the Federal Accounting Standards Board to ask for neutrality on accounting rules regarding risk hedging.
He did not elaborate on how, specifically, he would ask the FASB to treat standardized derivatives contracts differently.
But Robert Davis, an executive vice president at the American Bankers Association, said the requirements for contract specificity stemmed from a complicated rule, FAS 133, and any alteration to its treatment of the contracts would represent "a watershed change."
During the press conference, the two chairmen took time to emphasize their close cooperation. Frank said the agreement he and Peterson had reached thus far defied "the expectations of many and the hopes of some."
Whether bankers will find much success in attempting to change the bill is unclear. The largest banks, who care the most about derivatives, are in the weakest political position. Still, some analysts warned that as the two committees work through the bill, differences could emerge.
"From time to time you'll see agreements between committee chairmen, and then you have to let the political process play out," Gardner said. "I suspect that something close to this will probably be in the end product."