By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®
On May 20, the Senate passed the Wall Street Reform bill, its version of regulation aimed at the financial services industry. While the entire insurance industry warily eyes financial services reform--wondering whether it will get lumped in with banks--one particular niche of the industry is pretty certain of an impact--the weather risk management market.
In particular, changes to how derivatives are regulated will clearly affect an industry that enjoyed the exchange of $15 billion in weather risk contracts--largely over-the-counter (OTC) derivatives--between April 2008 and March 2009.
The bill passed by the Senate closely matches many of the OTC derivatives provisions found in the bill passed earlier by the House of Representatives, with both requiring regulation of swap dealers and major participants and both requiring the clearing and trading of OTC derivatives on markets, according to an analysis of the bills by the international law firm Clifford Chance. Some differences exist between the House and Senate bills. Those should be ironed out in committee. Expectations are that Congress will adopt the final law by July 4.
Obviously, the impact of derivatives regulation will depend on how negotiations play out between the House and Senate, but given the similarities between the two bills, it's safe to prognosticate a little here.
One surprising possibility could be that increased regulation would benefit the weather market, according to Lynda R. Clemmons, a New York-based executive vice president, weather, with Vyapar Capital Market Partners, a brokerage firm that specializes in OTC products. With a resume that goes back to the days of weather trading at Enron, Clemmons suggested that players might be more willing to be involved in the weather market with clearinghouses involved because counterparty risk would not as big an issue.
On the other hand, she added, "change can also have a debilitating effect on people's desires to transact."
That's particularly true if the new regulations play out before the end of this year.
For derivatives clearing and trading, the new regulations are set to kick into effect 180 days after the bill's enactment, though the Senate bill affords grandfathering in of deals done before enactment. For registration for dealers and participants, that would go into effect one year after enactment.
Whenever things go into effect, the consequence will be more regulation, and more powerful regulators.
"An awful lot of discretion is being given to the regulators," said Claude Brown, a partner in the London office of Clifford Chance, who explained the potential impact of reform at the annual meeting of the Weather Risk Management Association (WRMA) in May.
It shows, Brown said, that legislators might not understand just how difficult it is to standardize over-the-counter transactions such as weather deals.
For Clemmons, it's an indication that lawmakers are "fixated" on banking, and are not as aware as maybe they should be of the impacts upon such derivative users as the energy sector and the weather risk management market.
In large part, much of this regulatory power will fall upon the Commodity Futures Trading Commission (CFTC) to determine what swaps need to be cleared, or which swap participants are "major" and thus need to register. It will be up to these regulators, under the Senate version, to determine if a participant is an "end user"--in other words, using the deals to hedge business risks, versus doing deals for speculative purposes. (End users are exempted from needing to use clearinghouses and exchange trading.)
"You go from being a 15,000-foot-view regulator to down in the trenches deciding what kinds of companies can trade what kind of derivative products," Clemmons said of the CFTC. "It screams backlog."
In the very least, giving new job descriptions to regulators that aren't used to them will lead to uncertainty in the markets, said Brown.
One solution might be for derivative traders and end users to flee to another jurisdiction. But don't go to Europe.
As Brown said, there, "the days of light-touch regulation are over." Instead, regulators are going for a "conscious penalization of OTC trades."
June 1, 2010
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