While the legislation passed by the Senate Agriculture Committee last week would make some big changes in the derivatives market, it allows non-financial corporations that hedge their risks with derivatives to continue using customized over-the-counter instruments. Corporate end users still have problems with the Agriculture version of derivatives reform, though, including its cloudiness about the definition of an end user.
While the Agriculture Committee bill, sponsored by committee chairwoman Blanche Lincoln (D-Ark.), recognizes the needs of corporate users of derivatives, "the legislation still does fall short and picks some winners and losers in the corporate world," says Cady North, manager of government affairs for Financial Executives International (FEI).
In the wake of the financial crisis, legislators have been working on ways to get more derivatives activity onto exchanges, where it would be more transparent. Corporate users argue that the standardized derivatives on exchanges would be less useful to them than customized OTC instruments, and also more expensive.
While the Senate Agriculture measure exempts non-financial corporates from requirements to trade on exchanges, a lot of companies aren't certain whether they will qualify as an end user according to the definitions set forth in the legislation, North says. "They're unsure right now whether they are going to have to centrally clear some of those contracts--exchange trade some of their contracts--and thus be subject to those margin requirements and collateral requirements."
She cites, for example, agriculture companies that have finance units that assist customers with financing purchases. And she notes that the portion of the bill that defines end users includes a clause that says the Commodities Future Trading Commission (CFTC) can modify that portion of the legislation at any time, adding to the uncertainty.
As a whole, the legislation leaves a lot of power with the CFTC and the Securities and Exchange Commission, North says. And unlike the other derivatives measures, it would include foreign exchange forwards and swaps, although it gives the Treasury Secretary the power to exempt them from regulation.
In many respects, the Agriculture Committee's measure is more far-reaching than other measures, including the financial reform measure the House passed late last year. The Agriculture bill would push banks to spin off their derivatives units by barring financial institutions that trade derivatives from federal assistance, including access to the Federal Reserve's financing window.
North says removing banks from the derivatives business would pose a problem for corporations, which trade derivatives almost exclusively with their banks. "If banks are required to spin off their swaps business, that relationship will no longer exist and significant risk will be concentrated among likely a very small number of investment banks and corporate end users will probably no longer have a good competitive counterparty to trade with," she says.
Of course, the Senate Agriculture Committee's bill is just one of several versions of derivatives reform, and it's unclear which version will become law. The Senate Banking Committee also passed a measure, which did not exempt end users, but North says it now seems likely the Agriculture measure will be used as the derivatives portion of the Senate's broader Wall Street reform act. "The leadership has said it would like this passed before the Memorial Day recess," she adds.