Senators at odds over derivatives end-user exemptions

The debate on end-user exemptions from derivatives legislation heated up yesterday, as one senator condemned the derivatives bill passed in the House of Representatives on December 11 – the Derivatives Markets Transparency and Accountability Act. The attack from senator Maria Cantwell comes just weeks before the Senate is due to debate its own version of the legislation, which is expected to mirror the exemptions contained in the House version.

Two Senate committees are drafting separate pieces of legislation, which should be introduced into the Senate in the next few weeks. The Senate Committee on Banking, Housing and Urban Affairs, chaired by Christopher Dodd, is attempting to draft a bipartisan bill led by senators Jack Reed and Judd Gregg – members of the committee. Meanwhile, the Senate Committee on Agriculture, Nutrition and Forestry, chaired by Blanche Lincoln, is working on its own version.

Both committees are trying to come up with a definition of a major swap participant, which will determine who is subject to the legislation and whether end-users are dragged in. The Senate Banking Committee is still grappling with a definition.

"We are working aggressively to come up with a workable definition on who would be covered and who would be exempt under the definition of a major swap participant," says the Senate Committee on Banking, Housing and Urban Affairs' Gregg in an exclusive interview with Risk. "The big question is how to treat end-users. Clearly, if an end-user is using a swap or derivative for the purposes of hedging its business risk and is protecting itself, it will probably be exempt. But there is a lot of grey area here and we are trying to figure out the grey area. We have taken into consideration the administration's views and the House views, and we think we are all in the same ballpark – it is just a question of nuance."

End-users fear being caught by the definition because it would mean standardised swap contracts would have to be traded on a designated contract market or alternative swap execution facility and cleared through a registered clearing house. Corporates claim this will hamper their ability to hedge, not only because they would have to post initial and variation margin – potentially eating into precious working capital – but also because it could stop them meeting hedge accounting requirements, as standardised, exchange-traded contracts would not match the exposures on their balance sheet.

'Riddled with loopholes'

However, senator Cantwell yesterday claimed the House bill was flawed and called for all standardised derivatives to be moved onto fully regulated public exchanges and clearing houses.

"The House of Representatives has passed legislation riddled with loopholes, which will not result in change. I will be fighting in the Senate to pass strong legislation to repair the failed financial regulatory system, and I will be working to close all loopholes to prevent any return of risky business," she said.

There are still questions about which way the Senate Banking Committee is heading with its definition and some lobbyists have expressed fears it could come out with a much broader definition than the House version. However, the Senate Agriculture Committee is expected to mirror the House definition and will have to be reconciled with the Banking Committee version. Lobbyists are confident the definition will be as narrow as the House version.

The Senate is also expected to pass similar clauses to the House on the clearing determination requirement – how swaps are deemed suitable for central clearing. Under the House bill a swap would have to be cleared if a central counterparty accepts it for clearing and the regulator determines the swap is required to be cleared.

"My theory is that we should lessen the bureaucratic interference and allow the market as long as it's using clearing houses and marking to market to take care of the process," says Gregg. "But the regulators need the authority to be able to step up and deem certain swaps to be cleared through a clearing house. This ability needs to be vested with regulators. There should be a relationship between regulators and clearing houses."

Too big to fail?

However, the Senate is expected to differ from the House on prohibition of government assistance to central counterparties in the event of a default or bankruptcy. The House bill explicitly bars federal assistance to support clearing operations or the liquidation of a derivatives clearing organisation. This includes making loans to, or purchasing any debt of a clearing counterparty; purchasing assets; assuming or guaranteeing obligations; or acquiring any type of equity interest or security.

"This is going to be a big debate in the Senate," says one industry lobbyist. "The inclusion of the latter provision in the House bill was in response to purely political arguments about future bailouts. It wasn't a logical clause, simply a response to political pressure. So this might be changed in the Senate."