It was no secret that the Obama administration was gunning for strict regulation of the previously unbridled over-the-counter derivatives markets.

But bankers were still caught off guard by the apparent severity of the 115 pages of legislation the Treasury Department released this month. The Treasury's bill is stricter than the rules under discussion by the House. In addition, bankers and other market participants will have less room to combat the proposal as regulators, lawmakers and the administration maintain a more unified stance on derivatives regulation than on any other area of financial regulatory restructuring.

The bill "would significantly change the derivatives market, principally for dealers," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics. "It's certainly a far-reaching legislative proposal that, because, I think, of the detail and the sophistication of the drafting, will have a lot of impact on the debate going forward."

The section of the plan that concerns them most is the proposed margin and collateral requirements for OTC counterparties. Under the bill, regulators could impose stringent requirements on both parties to trades still carried out over the counter.

The move is designed to force more trades through clearing platforms, which require all participants to essentially prove they have enough cash on hand to pay in the event of a loss in the trade. Though banks accept other types of collateral, clearing platforms want liquid collateral.
Ultimately, this could force a number of smaller customers out of the market altogether, depleting the volume of the derivatives business just as new transparency rules cut into its profitability.

"It is not fully clear what all of the unintended consequences are of the legislation for the end users," said Ernest Patrikis, a partner at White & Case LLP. "Will it make it more difficult for them to manage their risk, more expensive for them to manage their own risk, to the degree where it discourages them?"

Patrikis said that some regional banks that use swaps to hedge their interest rate exposures could suffer, simply because they would be required to post excessive collateral. In the end, it would be too expensive to make it worthwhile.

"There's an opportunity cost. Banks like to lend," Patrikis said. "If everybody has to post collateral there's going to be a lot of the asset side of the bank that's pledged, and that's not a bank anymore."

The banking industry is pushing back against the new requirements.

"Not everything can be cleared; not every product lends itself to being exchange traded," said Scott DeFife, a lobbyist for the Securities Industry and Financial Markets Association. "The industry believes in increased transparency, accountability and responsibility — all of these things are appropriate, but you have to maintain a role for customized products."

Administration officials appear ready for a fight — and unlike on other parts of the regulatory restructuring plan — enjoy significant political support.

The Treasury's bill proposes "significant change in the marketplace in a huge sector that's never been regulated," said Michael Barr, assistant Treasury secretary for financial stability, adding that the Obama administration is prepared to battle it out with the industry. "I think we're going to have a big fight," he said.

As is true for other parts of the administration's regulatory reform proposal, not all lawmakers are on the same page. For instance, a set of rules that House members had begun to draft would have offered a more generous carve-out for companies wanting to use derivatives to hedge their risk.

Also, some in the House are still calling for a partial ban on credit-default swaps, and a proposal being developed by House Financial Services Committee Chairman Barney Frank, D-Mass., and Agriculture Committee Chairman Collin Peterson, D-Minn., would divide jurisdiction differently between the two main candidates for derivatives regulator, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

On the Senate side, a bill proposed by the Agriculture Committee's chairman, Sen. Tom Harkin, D-Iowa, would ban OTC derivatives by forcing all derivatives onto exchanges.

But these differences, unlike those that have emerged in other areas of the financial regulatory reform effort, do not seem to be throwing the potential for strict regulation into turmoil.
"Treasury has given us a very good proposal," said a spokesman for the Financial Services Committee. "We do not differ in any way in the fact that derivatives, currently unregulated, need to be regulated going forward. … There are going to be differences between us and Treasury. We are going to legislate things. We are going to compromise."

Most observers think a derivatives bill could pass through the House quickly and that the real fight over the details of the new regulation will take place in the Senate. But much of the initiative on that side could come from the future regulators themselves: the CFTC and the SEC. "I suspect that, if CFTC Chairman Gary Gensler has pretty well cut a deal with Michael Barr over at Treasury, that the Senate will probably go with that," said Lynn Turner, a managing director at GlassLewis.

With the health-care debate and climate change legislation dominating many of the Senate Banking Committee members' agendas now, derivatives regulation looks like it won't produce a lively fight. "It's a complex area. Most of the senators are probably not going to be people who could get in and understand that much anyway," Turner said.

Gensler has recently demonstrated a new gusto for strict oversight of the derivatives markets. A week ago he sent a letter to the Senate Banking and Agriculture committees outlining amendments he thought should be made to the Treasury bill. They call for a further tightening of the rules, including a further increase in collateral requirements for some market participants.
The Treasury bill would give the CFTC jurisdiction over derivatives of broad-based indexes, including interest rate indexes. This would give the CFTC oversight of a wide range of commonly used credit derivatives, including some credit-default swaps.

The biggest conflict of all, Turner said, could come after a derivatives bill is signed into law, when the CFTC and the SEC finally have to hash out rules and guidelines for the derivatives markets. But the agencies may cooperate willingly: they announced Thursday that they will hold joint meetings at the beginning of September to discuss harmonizing their regulatory practices, including their future approaches to derivatives.

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