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Opalesque Futures Intelligence

Regulators: What does the “Wall Street Reform” Act of 2009 mean for futures traders?

Thursday, January 07, 2010

Ups and Downs of Changing Landscape

The US House of Representatives passed a sprawling bill, called the Wall Street Reform and Consumer Protection Act of 2009 or H.R. 4713, in December. Derivatives trading and investment advising are among the many activities affected by the 1,300-plus-page regulatory behemoth.

While additional provisions may be inserted into the bill as it makes its way through the Senate and the final law may be different, much of what’s there will probably remain. The table below lists certain items relevant to commodity trading advisors and futures markets.

Regulators blame unregulated credit default swaps for the collapse of Lehman Brothers and the difficulties of AIG, the insurance company. So, moving these over-the-counter derivatives to clearinghouses is a top priority. The main issue is that a handful of big dealers, especially investment banks, control OTC derivatives and have an advantage in price information.

Commodity Futures Trading Commission Chairman Gary Gensler recently commented: “Can you imagine if other markets operated similarly to the over-the-counter derivatives marketplace, where the dealer is the only one with the information? It would be like buying an apple from the supermarket when the price of the apple is kept private.”

By contrast, of course, futures and options on futures are regulated and traded on exchanges. The Futures Industry Association says it has long favored “closing gaps in the regulation of derivatives and promoting the value of the price discovery and hedging benefits provided by futures markets.”

The Association, in a statement on the topic, described the 2009 bill as an important step in this process and said, “We look forward to working with the Senate to further improve this legislation.”

The US is not the only country moving to regulate OTC derivatives. The European Commission announced a similar agenda in October, including higher capital requirements for customized OTC derivatives transactions and mandates that all standardized contracts be traded in regulated venues.

“It is encouraging that Europe and the United States are moving in the same direction regarding regulatory reform,” Mr. Gensler told the Global Markets Advisory Committee in December. “Reform starts with bringing transparency to the opaque over-the-counter markets,” he said.

Futures traders may benefit if OTC derivatives become more like futures and trade in venues where prices are transparent and counterparty risk is controlled. This could eventually result in new markets where there are opportunities to implement some futures trading strategies.

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Wall Street Reform Act of 2009, Selected Highlights

Regulate over-the-counter derivatives, with certain exceptions

Require hedge fund managers to register with the SEC

New rules for advisors registered with both SEC and CFTC

Assessments on broker-dealers for investor protection fund

Account protection for futures contracts held in a portfolio
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Double Registration

Another part of H.R. 4713 could be less benign. The bill requires hedge fund managers, including those already registered with the CFTC, to register with the Securities and Exchange Commission. This may mean more record keeping and time spent responding to SEC questions and examinations.

However, the bill exempts managers with less than $150 million in assets under management, so it will not affect smaller commodity trading advisors. For those with over $150 AUM, new rules are to be determined. The Act directs the CFTC and the SEC to establish rules as to the form and content of reports to be filed by investment advisors that are registered with both agencies.

This is to be done within 12 months after the enactment of the Private Fund Investment Advisers Registration Act of 2009 and the governors of the Federal Reserve System are also to be consulted. Congress appears to believe that the SEC and CFTC will work together effectively, while liaising with the Federal Reserve.

Mr. Gensler has said that his “agency has a long history of cooperation with other agencies, including periodic joint enforcement meetings, memoranda of understanding and surveillance briefings.” But there have been stories of bureaucratic turf battles between the SEC and the CFTC, going back years.

Moreover, the reporting requirements for double-registered advisors will serve a number of different goals. The SEC is supposed to prevent fraud by individual advisors. But the main rationale for the new legislation is to nip in the bud future financial crises. Systemic risk management became a priority after the 2008 shock.

Hence the role of the governors of the Federal Reserve System in setting reporting requirements. They are likely to want information on leverage, for instance, for the purpose of monitoring systemic risk.

Energy Futures

On a separate issue, the CFTC continues to consider whether to set position limits in energy markets. The agency appears to favor doing so. Mr. Gensler says there are position limits in many agricultural markets.

“In setting position limits for certain agricultural commodities, the CFTC sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,” he says. “Similarly, working with the exchanges, such position limits were set for energy futures as recently as 2001.”

Another argument regulators make in favor of position limits is that energy futures are a large and important market. More than 315 million energy futures and options contracts were traded on CFTC-regulated exchanges through October of 2009. The largest contract in crude oil by volume, NYMEX’s West Texas Intermediate, accounted for 114 million contracts, equivalent to 114 billion barrels of oil with a notional value of nearly $7 trillion, according to Mr. Gensler.

In 2008, Congress gave CFTC more authority over certain energy derivatives trading. Contracts traded on exempt commercial markets can be subjected to the same regulation as exchange-traded futures if they have a significant price discovery function. In July the CFTC decided that the ICE Henry LD1 Fixed Price Contract traded on the Intercontinental Exchange has such a function.

More than 40 additional energy contracts, including natural gas and electricity contracts currently traded on exempt commercial markets, are being considered for their role in price discovery. The regulator asked for public comment on these contracts. Clearly, there is a trend to extend futures regulation to instruments that trade outside regulated exchanges.
 



 
This article was published in Opalesque Futures Intelligence.
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