For three years, we've been hearing Washington legislators and bureaucrats sound off on the sorry state of derivatives legislation and the need for drastic overhaul. Now, a mere five months before the October 1 expiration of the Commodity Exchange Act, precisely how over-the-counter derivatives will be regulated—that is to say, unregulated—is still anyone's guess.

But that's not for lack of effort. In the last month, there's been a flurry of activity in Washington. Congress, having shaken off its three-year slumber, rolled up its sleeves and resolved—finally—to get something done.

On April 6, Rep. James Leach (R-Iowa), chairman of the House Banking and Financial Services Committee, added an intriguing twist to the legislative process. Having witnessed the House and Senate Agriculture committees fail thus far to deliver on their promises to change derivatives legislation, he introduced H.R. 4203, the "Over-the-Counter Derivatives Systemic Risk Reduction Act of 2000,” which would, once and for all, remove OTC derivatives from the purview of the Commodity Exchange Act. The bill would establish legal certainty for OTC derivatives, create a regulatory framework for the clearing of OTC derivatives under the supervision of the Federal banking agencies, and clarify the lawfulness of the use of multilateral clearing systems for OTC derivatives.

The bill is unprecedented, for it would effectively remove the House and Senate Agriculture Committees from the OTC derivatives legislative process. Taking some of the principles from the President's Working Group on Financial Markets, the bill would reduce legal uncertainties surrounding trading in swaps and related OTC financial derivatives, and would authorize multilateral clearing of these instruments and electronic trading of them.

"These steps,” Leach said, "would lower the risks to the financial system. By allowing for multilateral clearing organizations, the legislation provides for supervision of risk in a currently unregulated market,” he continued. "While a swaps clearing facility exists in London, current regulations of the Commodity Futures Trading Commission (CFTC) make it nearly impossible in the United States. The approach advanced in this bill is designed to ensure American market leadership.”

Leach's bill is unprecedented, for it would effectively remove the House and Senate Agriculture Committees from the OTC derivatives legislative process.

The bill's language is forceful. Among its assertions:

"Questions about the enforceability of over-the-counter derivatives contracts under Federal and State law could have a negative impact on the stability of the financial institutions that are parties to them and could threaten the safety and soundness of the financial system.”

"Interpretations of Federal law suggesting that the use of certain electronic technologies in the trading of over-the-counter derivative instruments might raise questions about their lawfulness have hampered the development of more efficient trading systems and, therefore, more effective risk management for financial institutions.”

"Federal supervision of multilateral clearing systems for over-the-counter derivative instruments markets will foster the effectiveness and integrity of the operations, the risk management of such systems, and the stability of the financial markets and the safety and soundness of the banking system.”

The bill was meant to serve as a wake-up call to the House and Senate Agriculture Committees, and it succeeded—although not immediately. "It is a rather complicated issue that you can't just rush,” said Chris Matthews, spokesman for the House Agriculture Committee. "There's just no clear and easy way to get legislation out there. Things like that take time and are serious endeavors.”

Evidently not too much time, however. Within two weeks of the introduction of the Leach bill, Rep. Thomas Ewing, R-Ill., chairman of the House Agriculture Subcommittee on Risk Management, sent a draft bill of his own to exchange leaders, derivatives professionals and other legislators. Ewing's bill—which hasn't been introduced yet—would transform the CFTC from a front-line regulator into an overseer, exclude OTC derivatives products from commodities laws and repeal the ban on single-stock futures contracts included in the Shad-Johnson Accord. And, taking a swipe at the Leach bill, it would clarify that the CFTC—and not banking regulators—has explicit regulatory authority over clearinghouses that process futures or OTC transactions.

Ewing's bill adopts many of the provisions the CFTC itself outlined in a recent release called "A New Regulatory Framework” (see "The CFTC Recasts Itself,” April). The exchange-friendly proposal found support at the Chicago Mercantile Exchange. "The Ewing bill represents a comprehensive framework for regulatory relief, reform of Shad-Johnson and legal certainty for over-the-counter markets,” the exchange said in a release. "It appears to treat all the parties seeking reform of the CEA (Commodities Exchange Act) fairly.”

Not to be outdone, Sen. Richard Lugar (R-Ind.), chairman of the Senate Agriculture Committee, released a draft bill to industry leaders that is quite similar to the Ewing bill. In a nutshell, Lugar's proposal would exclude OTC derivatives transactions from the Commodity Exchange Act, ease regulation of futures exchanges and allow the trading of single stock futures. The reaction was positive. Stacy Carey, the director of North American regulatory policy for the International Swaps and Derivatives Association, says the Lugar bill is the best of the three, striking the right balance in providing legal certainty for OTC derivatives transactions, regulatory relief for U.S. futures exchanges and—unique among the three bills—comparable treatment for energy derivatives.

Lugar is expected to introduce a formal bill this month, and joint hearings before the Senate Agriculture and Banking Committees are expected shortly thereafter.

The complex legislation isn't easily understood, even among Washington's wonkiest. This being an election year, the House and Senate will have to roll up their collective sleeves and get busy. The clock is ticking.

One Step Closer to Hedge Fund Regulation? Slowly but surely, the world's financial community is embracing the idea of regulating hedge funds. In March, the Financial Stability Forum, a coterie of prominent regulators from G-7 nations, as well as the World Bank, International Monetary Fund and the Bank for International Settlements' Basel Committee on Banking Supervision, met in Singapore to discuss policy actions aimed at reducing financial vulnerabilities resulting from highly leveraged institutions. It came up with more than a few. The group, headed by Howard Davies, chairman of the U.K. Financial Services Authority, was first convened after the Long-Term Capital Management debacle. In its latest report, it examined the effects of the infamous hedge fund implosion. It said there are two key issues that arose from LTCM: how best to address the systemic risks arising from the accumulation of high levels of leverage in financial markets; and how to reduce the potential market and economic impact of the sudden and disorderly collapse of an unregulated HLI. In the market conditions of late 1998, says the report, the disorderly liquidation of a hedge fund as large and as leveraged as LTCM could also have imposed substantial direct losses on its counterparties. Significant secondary losses could have been imposed on other firms, through the rapid liquidation and closing out of LTCM's positions and the collateral supporting its funding. The potential widespread disruption in financial markets and possible collapse of some major firms would have posed grave dangers to the stability of the financial system and the health of the global economy. The report stresses the importance of leverage, particularly in the context of large players with complex market and credit exposures. "Although leverage itself is neither strictly synonymous with risk nor straightforward to define,” says the report, "high leverage—and its interaction with other elements of risk—can nevertheless produce significant concerns from the perspective of the financial system as a whole.” With this in mind, the report recommended a package of measures including strengthened risk management practices by HLI counterparties and HLIs, enhanced regulatory oversight of HLI credit providers, enhanced public disclosure by HLIs and other counterparties, guidelines on good practices for foreign exchange trading, and building a firmer market infrastructure. The group also considered, but fell just short of recommending, direct regulation of currently unregulated HLIs. "We believe that disclosure is a preferable route to the one of direct regulation at this stage,” said Davies. "We hope that will generate the kind of market discipline that is required in order to prevent firms from building up large amounts of leverage, which can put systemic stability of financial systems at risk.” But Davies did not rule out direct regulation altogether. "We keep direct regulation on the table,” he said, "in case the market disciplines reinforced with legislative disclosures don't deliver the kind of safer conduct that we require.” With a virulent hedge fund regulation bill already before Congress, the days of stealthy hedge fund dealings may be coming to an end.