From the August 01, 2010 issue of Futures Magazine • Subscribe!

Are U.S. markets ready for reform?

One industry insider noted that the percentage of OTC trading could actually rise as a result of the end user exemption in the legislation. He says, “much of the risk of a future meltdown will persist as a result.”

The legislation also codifies the authority of the Commodity Futures Trading Commission (CFTC) to establish position limits, including aggregate position limits applied to both OTC positions and exchange traded futures. While most of the provisions in the bill won’t take affect for over a year after passage, the CFTC is to enact these limits 180 days after passage for exempt commodities and 270 days for agricultural commodities.

Jon Corzine, chairman and CEO of MF Global and a former legislator and head of Goldman Sachs, expressed general support for the bill (prior to it passing the House) but had issues with the Volcker rule.

“The idea of prohibiting proprietary trading in some of our larger institutions, to spin off derivatives books, is not a good idea,” he said. “Somebody is going to want to have their risk intermediated and it is going to go somewhere. If it is not in the banking system, it may go someplace where it is less easy to observe, more expensive to access and may even be offshore.”

Based on initial analysis of what parts of the Volcker rule are actually in the legislation, Corzine and others objecting to it don’t have much to worry about.

Originally the rule would have prevented any systemically important bank holding company from engaging in proprietary trading as well as investing its own capital in hedge funds or private equity funds. Instead of the outright ban originally proposed, the final version will allow banks to provide no more than 3% of a fund’s equity, and will be limited to investing up to 3% of the bank’s Tier 1 capital in hedge funds or private equity funds.

Further, an amendment proposed by Sen. Blanche Lincoln (D-Ark.) requiring banks to spin off a portion of their proprietary trading with their own capital was weakened. While the original amendment required banks to spin off all their proprietary trading or else lose FDIC insurance, the final version only requires banks to spin off the riskiest parts of their trading, primarily credit default swaps.

Although the bill was already formed at the time, CFTC Chairman Gary Gensler testified before the Financial Crisis Inquiry Commission on July 1 specifically about the role OTC derivatives played in the financial collapse.

“Another lesson from the financial crisis was that the entities that made markets in derivatives were ineffectively regulated or sometimes not regulated at all. The derivatives affiliates of AIG, Lehman Brothers and Bear Stearns had no effective regulation for capital, business conduct standards or recordkeeping. Without such comprehensive regulation, they were relying mostly on their own risk management practices and profit motives to determine how much capital they would have to keep and what other business decisions they would make,” Gensler says.

Consequently, the new financial bill aims to bring greater regulation to the OTC derivatives market by granting the CFTC and SEC greater authority to regulate irresponsible practices and excessive risk taking (see “Reading the fine print,” below). Further, the bill mandates central clearing and exchange trading for derivatives that can be cleared, although it will be left to regulators to determine which derivatives those include. Ideally, this will provide more transparency in pricing and more liquidity in the system.

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