This alert builds on the first alert in the series which explored possible reforms of the entire derivatives industry within the European Union and provides a detailed overview of the key elements of US reform proposals in the context of their significance to commodities traders.

Although the US proposals also impose further regulation on clearing houses, these fall outside the scope of this alert.

2. The Reform Proposals
There are currently three reform proposals before Congress that, if enacted, will restructure the regulatory framework of the OTC derivatives market. Commodities traders who use these markets either as part of their trading business or to hedge underlying physical positions, will be subject to increased regulation and reporting requirements. It is therefore essential, even at this early stage in the legislative process, to understand what is on the regulatory horizon.

The three reform bills which are currently under consideration by US lawmakers are:

1. the "Obama Proposal" which was submitted to Congress by the Administration on
   11 August 2009;¹
2. the "HFSC Proposal" which was submitted by the House Financial Services Committee on 2 October 2009, and was later revised and subsequently approved in its first committee hearing on 15 October 2009;² and
3. the "HAC Proposal" which was submitted by the House Agriculture Committee on 9 October 2009;³

(together the "Proposals").

Each proposal is summarised in Appendix 1 to this client alert and it is clear that they share many characteristics, though there are differences in the detail. The key themes of the reform proposals are mandatory clearing, exchange trading, capital requirements, margin requirements, position limits and both disclosure and reporting obligations. There are also provisions regarding registration, back-office operations and conduct of business.

Under the Obama Proposal, "swap" is defined broadly (as above), although a swap must be "standardized" to fall under its remit. Initially, a swap will be automatically deemed to be standardized should a clearinghouse be willing to accept the swap for clearing (though the Regulators have 180 days after enactment to further define this term).

Who will be affected?
The Proposals apply to a wide category of market participants, including two new regulated classes of market participants: "Swap Dealers" and "Major Swap Participants" (as defined in Appendix 1) (together "Regulated Parties").

Most commodities houses are unlikely to qualify as "Swap Dealers" (these are major financial institutions) but may fall in the category of Major Swap Participant which is subject to a hedging exception in the HFSC and Obama Proposals.

Under the Obama Proposal, a company is not deemed to be a Major Swap Participant if it uses the markets only as an "effective hedge under generally accepted accounting principles" (to be defined further by the Regulators).

The HFSC provides for an even-wider exception by "excluding positions held primarily for hedging, reducing, or otherwise mitigating commercial risk" and from the point of view of physical commodities traders, the wider the carve-out the better.

However, under the HFSC definition, parties that hold substantial net positions in swaps or whose outstanding swaps create substantial net counterparty exposure that would expose counterparties to significant credit losses that could have a material adverse effect on their capital are included irrespective of whether the positions where acquired for the purpose of hedging or otherwise.

The scope of the above exceptions (as it were, the exceptions to the wider hedging exception referred to above) is very wide in that, arguably, anyone not having a perfectly balanced book could be said to be holding a net position (a proprietary position that is). Equally anyone that is not fully collateralized and who has no certainty as to the reliability of close out netting does arguably bear counterparty risk.

The Regulators have an obligation to jointly define "substantial net position" and "substantial net counterparty exposure" within 60 days of enactment. The HAC proposal does not provide for a hedging exception, meaning all US OTC derivative traders would be subject to the legislation.
If a commodities trader can successfully argue that it falls outside of the definition of a Regulated Party then it may not be subject to many of the requirements of the Proposals such as mandatory clearing and exchange trading. The interpretation and subsequent definition of Regulated Party will therefore be critical.

Mandatory Clearing & Exchange Trading
When issuing its legislative proposal, the Administration identified that a key risk to market stability is "the web of bilateral connections among major financial institutions". This risk is also the impetus behind the push for mandatory clearing and exchange trading, as it is thought that clearing and exchange trading will also provide markets with increased price discovery mechanisms. This underlying theme is reflected in all of the Proposals.

The Obama Proposal requires clearing by Regulated Parties of all standardized trades and contains a requirement for clearinghouses to ensure that all swaps with the same terms and conditions are fungible and may be offset with each other. Additionally these cleared, standardized trades must be traded on a board of trade designated as a contract market (i.e. an exchange) or traded on a registered "alternative swap execution facility" (a facility which must be registered as such under the proposal).

Where a clearinghouse will not accept a trade for clearing (for example, because the trade is it too customised), or where one of the counterparties to the swap is not a Regulated Party and a clearinghouse will not accept the trade, then mandatory clearing and exchange trading will not apply to that trade. In such a situation, both parties to the swap must report the trade to a swap repository. If there is no such suitable repository, then the report must be made directly to the CFTC (within a timeframe which is to be defined). This is necessary as repositories will have to register with the Regulators and will be required to provide them with transaction data on a confidential basis. Regulators then have an obligation to publish such data (in aggregate) and need to have access to data on all trades.

This is a welcome fallback mechanism which is essential in the early stages of implementation of the new regulatory framework because currently not all OTC derivatives are suitable for exchange trading. If the aims of the Proposals are met, we should observe a high degree of market convergence and standardization over the coming years.

Initially, the HFSC provided for an alternative regime to the Obama Proposal which did not impose a blanket clearing and exchange trading requirement. However, on 14 October 2009 an amendment was passed which brought the HFSC Proposal into line with the Obama Proposal.⁴ As such there is now a presumption of a clearing requirement in all cases where a clearinghouse will accept the swap. Furthermore all qualifying OTC derivatives trades (i.e. all those to which a Swap Dealer of a Major Swap Participant is a party) must be entered into on or be subject to the rules of a board of trade designated as a contract market (i.e. an exchange). As a transitory measure, trades entered into within 90 days of enactment of the proposal, where one party is not a Regulated Party, need not be cleared.

The HAC Proposal is broadly similar to the HFSC Proposal with the exception that the HAC Proposal provides that a trade does not have to be submitted for clearing if one of the parties is not a Regulated Party and it can be demonstrated that the swap serves an appropriate business and risk management function. If there is no designated contract market or alternative swap execution facility, then exchange trading is not necessary.

Additional Regulation
As is clear from Appendix 1, the Proposals all provide for complex registration, reporting, disclosure, back-office and conduct of business rules. The Regulators have an obligation to provide "continuing obligation" rules which will apply to Regulated Parties, though until the Regulators fill in the gaps, we will not know the full scope of the rules.

Additionally the Proposals all regulate minimum capital and margin requirements. In particular, such requirements are more onerous for non-cleared / exchange traded swaps. The concern is that such additional regulation regarding minimum capital and margin requirements could decrease market liquidity and in turn increase hedging costs, making the markets less efficient.

Position Limits
All three Proposals include provisions that allow the Regulators to set position limits that traders can take in the same underlying commodity. The rationale behind these limits is a perceived correlation between the size of derivatives positions held by individual players, speculative commodity derivatives trading and resulting spikes in the spot price of the underlying commodity.

3. CFTC & SEC Reform
Regulators are also in the Administration's firing line. Currently the CFTC has authority over the futures markets and the SEC has authority over the securities markets. As the OTC derivative market has matured and developed, this distinction has blurred and in some areas it is now unclear as to which trades each body should govern. The Regulators jointly published a report on 16 October 2009 which provides recommendations to "fill regulatory gaps, eliminate inconsistent oversight and promote greater collaboration". The aim of the report is to realign responsibility and approach consistency between the Regulators.

An analysis of these recommendations, as they are developed further, will be the subject of a future client alert.

4. Conclusion
The overarching aim of the Proposals is to facilitate a migration of OTC derivatives onto cleared exchanges. The Administration believes that speculation in the derivatives market caused recent commodity price spikes and under the current regulatory framework, the Regulators had only limited powers of redress. In theory, the transparency that the Proposals provide will help to avoid such uncontrolled speculative trading and in particular, the spill over effects to the wider economy.

The effect on commodities traders and the commodities markets will depend largely on how the Regulators fill in the gaps, especially in areas such as minimum capital and margin requirements. In the meantime, it is now the turn of the lobbyists to comment on the Proposals and attempt to push through amendments.

1 http://www.financialstability.gov/docs/regulatoryreform/titleVII.pdf
2 http://www.house.gov/apps/list/press/financialsvcs_dem/discussion_draft_otc.pdf (original proposal); http://www.house.gov/apps/list/speech/financialsvcs_dem/markup_100809.shtml (Full Committee Markup, 1st Hearing).
3 http://agriculture.house.gov/inside/Legislation/111/JDG_372_xml.pdf

4 http://www.house.gov/apps/list/speech/financialsvcs_dem/otc_managers_amendment-revised.pdf

Appendix 1: Quick-look Summary of the Proposals
Obama Proposal (Obama Administration):⁵ Submitted to Congress on August 11th