ALERT: House Agriculture Committee Marked-up and Reported the “Derivatives Markets Transparency and Accountability Act of 2009” (H.R 977)

February 13, 2009

On February 12, 2009, the House Agriculture Committee marked up and reported the "Derivatives Markets Transparency and Accountability Act of 2009" (H.R 977), a bill introduced by Chairman Collin Peterson (D-Minnesota) that strengthens the regulation of over the counter (OTC) derivatives. This update summarizes key provisions of the legislation, including: (1) CFTC authority to suspend credit default swaps (CDS) trading; (2) requirement for clearing house processing of OTC derivatives through CFTC- or SEC-regulated clearing organizations with CFTC authority to exempt contracts from the clearing requirement; (3) trading limits to prevent excessive speculation; (4) transparency measure for CFTC detailed reporting and disaggregation of market data; (5) exemption for carbon offset credits and emission allowances; (6) CFTC authority to prosecute criminal violations of the Commodity Exchange Act; and (7) Diversity Requirement for Boards of Trade.

(1) CFTC Authority to Suspend Trading in Credit Default Swaps. The bill grants the CFTC authority to suspend CDS trading, with the concurrence of the President. This grant of authority is included in Section 16 of the bill. The measure defines the term "credit default swap" as a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade, and excludes exclusions from the definition. A CDS traded on or cleared by a registered entity will not be considered a security, except as necessary for enforcing insider trading prohibitions. This definition applies to CDSs entered into after 90 days after the date of enactment.

(2) Requirement for Clearing House Processing for Over the Counter Derivatives. Section 13 of the bill, as modified by Rep. Boswell’s amendment at the markup, requires that all prospective OTC transactions must be settled and cleared through a CFTC-regulated or SEC-regulated clearing organization. By way of background, a previous draft version of the bill had mandated all OTS clearing. However, the bill provides the CFTC with the authority to exempt contracts or classes of contracts from the clearing requirement if the contracts satisfy criteria (e.g. highly customized as to its material terms and conditions, infrequently transacted, does not have a significant price-discovery function in the market-place, and is being entered into by parties who can demonstrate the financial integrity of the transaction as well as their own financial integrity via standards to be determined by the CFTC including a stated financial and net capital requirements). The bill directs the CFTC to consult with the SEC and the Federal Reserve in granting such exemptions to financial derivative, with market participants required to report contracts subject to the clearing exemption. Notably, the bill further requires derivatives clearing organizations to publicly disclose derivatives information, margin-setting methodology, and other settlement and clearing information, and for the clearing organization to establish fitness standards for directors and disciplinary committees. Further, the bill (as modified by Rep. Pomeroy’s amendment in markup) requires the CFTC to hold two public hearings within 150 days after enactment of the bill, and biannually thereafter.

(3) Position Limits to Prevent Excessive Speculation. The bill requires the CFTC to set appropriate position limits for all physically-deliverable commodities to prevent excessive speculation. This provision is included in Section 6 of the bill, which sets forth that such position limit requirements shall apply to spot month, each month and aggregate positions held by a person for all months, taking into account the availability of other markets. The bill sets forth criteria for the CFTC to consider when establishing these position limits, including: (1) to diminish, eliminate, or prevent excessive speculation; (2) to deter and prevent market manipulation, squeezes, and corners; (3) to ensure sufficient market liquidity for bona fide hedgers; (4) to ensure that the price discovery function of the underlying market is not disrupted; and (5) the total number of positions in fungible agreements, contracts, or transactions that a person can hold in other markets. The bill directs the CFTC to establish such position limits with varying time-frame based on commodity type (within 90 days after enactment for exempt commodities and within 180 days after enactment for agricultural commodities). In addition, Section 6 of the draft bill clarifies the definition of a "bona fide hedging transaction or position" and includes a list of conditions for the CFTC to take into account in defining such transactions.[1] <http://us.mc373.mail.yahoo.com/mc/compose?.rand=1786463406&uc=1#_ftn1>

(4) Transparency Measure: Detailed Reporting and Disaggregation of Market Data. The bill includes a transparency measure requiring the CFTC to disaggregate and publicly provide the number and total value of positions of index funds -- and other passive, long-only and short-only investors -- in all regulated markets, and data on speculative positions relative to their bona fide physical hedgers. This provision is included in Section 4 of the bill, which also directs the CFTC to issue a proposed rule defining and classifying index traders and swap dealers for data reporting requirements and setting reporting requirements for transactions in designated contracts markets, derivative transaction execution facilities, foreign boards of trade (FBOT), and electronic trading facilities with respect to significant price discovery contracts. The bill directs the CFTC’s proposed rule to be issued within 120 days of enactment.

(5) Exemption for Carbon Offset Credits and Emission Allowances. Notably, the bill would provide that carbon offset credits and emission allowances are "exempt commodities" by amending Section 1(a)14 of the Commodity Exchange Act. The modified definition would include any allowance authorized under law to emit a greenhouse gas, and any credit authorized under law toward the reduction in greenhouse gas emission or an increase in carbon sequestration. The bill further directs the CFTC to establish an MOU with the USDA on development of procedures and protocols for market-based greenhouse gas program within 180 days after the date of enactment, consistent with Section 1245 of the Food Security Act of 1985, ensuring that the development of any procedures and protocols for a market-based greenhouse gas program are properly constructed and coordinated to maximize credits for carbon sequestration.

(6) CFTC Authority to Prosecute Criminal Violations of the Commodity Exchange Act. Section 17 of the bill grants the CFTC authority to initiate and conduct criminal litigation relating to a violation of the Commodity Exchange Act if the Attorney General has declined to do so.

(7) Diversity Requirement for Boards of Trade. The bill, as amended by Rep. Kissell’s amendment at the markup, authorizes the CFTC to require diversity in the compositions of boards of trade at the exchanges to get input from a variety of sources – from farmers, processors, various businesses, manufacturing and financial sectors, as well as those from diverse social and cultural backgrounds.

Chairman Peterson’s thirty-nine page bill includes a variety of other provisions relating to the regulation of OTC derivatives which are not discussed in this legislative update, including: transparency of offshore trading, transparency and recordkeeping authorities, changes in CFTC administration, a requirement for the CFTC and the GAO to issue reports on regulatory regimes for futures and derivatives trading, among other provisions.

[1] <http://us.mc373.mail.yahoo.com/mc/compose?.rand=1786463406&uc=1#_ftnref1> Section 6 of the bill requires the CFTC to define a "bona fide hedging transaction or position" as one that— ‘‘(A)(i) represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel; ‘‘(ii) is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and ‘‘(iii) arises from the potential change in the value of - ‘‘(I) assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; ‘‘(II) liabilities that a person owns or anticipates incurring; or ‘‘(III) services that a person provides, purchases, or anticipates providing or purchasing; or ‘‘(B) reduces risks attendant to a position resulting from a transaction that— ‘‘(i) was executed pursuant to subsection (d), (g), (h)(1), or (h)(2) of section 2, or an exemption issued by the Commission by rule, regulation or order; and ‘‘(ii)(I) was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction pursuant to paragraph (A); or (II) meets the requirements of subparagraph (A).’’

Written by Kirsten Wegner