The $600 trillion derivatives industry, and the big banks and traders that dominate it, will operate under new regulatory guidelines.  By the slim margin of 3-2, the CFTC voted on Thursday to adopt new rules for the biggest players in the derivatives world. Originally proposed in late 2010, the final rules spell out numerous requirements to bolster internal business standards - e.g., firms must manage risks posed by derivatives trading, prevent conflicts of interest and empower a CCO to prepare an annual report detailing a firm’s internal controls.

“It will lower the risk that swap dealers pose to the rest of the economy." -- Gary Gensler, CFTC.

Who's Affected. The rules apply to:  (i) swaps dealers (big banks, brokerages, large energy-trading firms that create derivatives contracts);  (ii) hedge funds, other traders that have large positions in swaps (derivative contracts tied to the value of commodities, interest rates and mortgage securities). How to Define Swaps Dealers? Not yet determined by the Commission;  nor has so-called "major swaps participants" been defined.  Definitions were expected on Tuesday, but the CFTC delayed the vote as other regulators finalized a similar rule. The Dodd-Frank Reform Act ... is the motivator for this new rule and a flood of others pertaining to derivatives.  With a mandate for greater federal oversight of swaps trading, the CFTC has so far adopted over 50 new rules. Under these new rules, banks and traders must:

• adopt new risk management policies to control for the danger and volatility that come with derivatives trading.
• must monitor the size of their trading positions to comply with laws that cap the number of contracts a trader can hold.

Conflicts of Interest. The rules also target conflicts of interest, introducing new requirements for firms to create firewalls that prevent, say, a derivatives trader from influencing the content of the firm’s derivatives industry research.  The rules also bar banks from offering favorable research to clients, or threatening negative reports, in exchange for potential business. Dissention on the CFTC. Voting against the rules were the 2 Republican Commissioners, who say the agency was overreaching the mandate Congress laid out in Dodd-Frank.  In a series of testy exchanges, dissenter Scott O’Malia pressed CFTC staff to justify what he called “duplicative” requirements.

“I believe the commission has failed to carefully and precisely identify a clear baseline against which the commission measured costs and benefits and the range of alternatives under consideration in this rule.” -- Scott O'Malia.

Chairman Gensler Counter Argument. Mr. Gensler recalled that, under the Clinton administration, the government exempted derivatives trading from new oversight.  This initiative allowed the industry to ratchet up risk in the lead up to the financial crisis.  While he had supported lax oversight when he served with the Treasury Department in the 1990s, Gensler said the crisis cast doubt on the wisdom of light regulation, adding:

“That was a false assumption and I will even say I was part of that assumption. That’s why I’m so happy today to be able to support this rule, that this agency does have a role and Congress asked us to do it.”

For further details, go to:   [Dealbook, 2/23/12].