Congress begins debate on regulation of financial 'WMDs'
Warren Buffett famously called derivatives financial weapons of mass destruction. That was before they detonated, propelling the financial system toward the brink of collapse. Then, as part of the Dodd-Frank Wall Street reform law meant to prevent future crises, Congress last year demanded a new system of regulation for the financial instruments.
Now a battle is brewing over the details of that regulatory regime.
Tuesday, a House committee operating under the new Republican majority is examining how regulators are writing rules that could determine the safety, efficiency and cost of derivatives.
The House Financial Services Committee is giving businesses a forum to air complaints that the emerging rules may be too confining.
The hearing comes one week after another House panel, the Committee on Oversight and Government Reform, signaled that it is examining the potential economic impact of derivatives regulation. The oversight panel invited business groups to identify regulations that threaten jobs, and some groups took the opportunity to complain about the Dodd-Frank reforms.
Though derivatives are often associated with hedge funds, investment banks and other financial institutions whose systemic importance can make them "too big to fail," Tuesday's hearing showcases a more benign face of the derivatives user: MillerCoors.
In prepared testimony, MillerCoors risk management director Craig Reiners says the brewing company uses derivatives not to speculate in the financial markets but rather to control for fluctuations in the price of barley, corn and hops - plus the energy that runs the breweries and the aluminum that goes into all those cans.
The "prudent use of derivatives by end-user companies, such as MillerCoors, does not generate risk or instability in the financial marketplace and played no role in the financial crisis," Reiners says.
If regulators aren't careful, they could deter companies like MillerCoors from managing risks, Reiner says.
Derivatives, which can be used to insure against risks or to make speculative investments, are contracts tied to some financial benchmark, such as mortgages, commodities or interest rates. For the most part, they have gone unregulated. Dodd-Frank generally calls for them to be traded on exchanges, like stocks, where the prices would be plain to see and it would be harder for firms in the business of minting derivatives to extract outsized profits.
The law would move toward standardizing what have often been custom-made financial contracts.
In addition, Dodd-Frank calls for steps to make sure the parties to those contracts have the financial wherewithal to make good on their commitments - for example, by putting money down. But business groups are arguing that such measures could force them to tie up capital that they could use more productively.
"Without care, there is a real risk that the current proposals will drive liquidity out of US markets and increase the cost of managing risk, if not eliminate altogether the ability to do so by making it prohibitively expensive, inflexible or burdensome," Don Thompson, a managing director at JPMorgan Chase & Co., says in testimony prepared for the hearing.
JPMorgan is a big middleman in the derivatives trade.
Congress gave regulators the latitude to treat the MillerCoorses of the world differently from the JPMorgans, and, speaking in the jargon of Wall Street, one of the regulators responsible for writing the rules says in testimony prepared for Tuesday's hearing that he would do just that.
"Transactions involving non-financial entities do not present the same risk to the financial system as those solely between financial entities," says Gary Gensler, chairman of the Commodity Futures Trading Commission. "Consistent with this, proposed rules on margin requirements should focus only on transactions between financial entities rather than those transactions that involve non-financial end-users."
Gensler opposed regulation of derivatives during the Clinton administration and has since reversed his stance.
"The reforms mandated by Congress will reduce systemic risk to our financial system and bring sunshine and competition to the swaps markets," he says in his testimony, referring to a form of derivative. "Lowering risk and improving transparency will make the swaps markets safer and improve pricing for end-users."
Another key regulator, Securities and Exchange Commission Chairman Mary Schapiro, says in prepared testimony that the rulemaking "is a very challenging task."
"The issues are complex and do not lend themselves to easy solutions," Schapiro says.
David S. Hilzenrath
| February 15, 2011; 9:21 AM ET
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