Crunch time for Wall Street

The United States Congress is on target to deliver a sweeping rewrite of Wall St's rules to President Barack Obama by July 4, meeting the deadline lawmakers set for themselves.

House and Senate negotiators, after a marathon 20-hour session on Friday, approved a bill aimed at increasing oversight and regulation of the US financial system.

They brokered last-minute deals on a ban on proprietary trading by banks and oversight of the derivatives market.

The House and Senate are scheduled to vote on the measure, which congressional leaders have said will not be further revised or amended, by the end of this week.

The Obama Administration's proposal to ban banks from proprietary trading, nicknamed the "Volcker rule" after former Federal Reserve Chairman Paul Volcker, was softened by Senate negotiators.

Banks will be allowed to invest in private-equity and hedge funds, though they will be limited to providing no more than three per cent of the fund's capital.

Banks also can't invest more than three per cent of their Tier One capital.

The change alters language in a bill the Senate approved in May, which would have barred banks from sponsoring or investing in private-equity and hedge funds.

The legislation defines proprietary trading as engaging as a principal for a trading account of a bank or non-bank financial company supervised by the Federal Reserve "in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument" that regulators designate through rule-writing.

Negotiators also agreed to give regulators less say than previously proposed to define a ban on proprietary trading.

The ban on propriety trading, in which a company bets its own money, may reduce profits. Goldman Sachs Group, the most profitable firm in Wall Street history, has said proprietary trading generates about 10 per cent of its annual revenue.

The firm made US$1.17 billion ($1.6 billion) last year from "principal investments", which include stakes in companies and real estate, according to a company filing.

Senate Banking Committee chairman Christopher Dodd also backed a plan to prevent firms that underwrite an asset-backed security from transactions that would result in a conflict of interest.

The conflict-of-interest provision seeks to address fraudulent conduct alleged in a Securities and Exchange Commission lawsuit against Goldman Sachs.

The SEC claims the bank created and sold collateralised debt obligations linked to sub-prime mortgages without disclosing that hedge fund Paulson & Co helped pick the underlying securities and bet against the vehicles. Goldman Sachs has denied wrongdoing.

After spending months crafting legislation, lawmakers pushed through a last-minute deal on what they termed the most challenging part of their task - establishing for the first time a regulatory structure for the $615 trillion over-the-counter derivatives market.

The most contentious part of the derivatives rules is a provision that will force banks to push some of their swaps-trading into subsidiaries, on the theory it would reduce taxpayers' risk if the trades are walled off from depositary institutions that enjoy federal benefits such as access to the Federal Reserve's discount lending window.

The original proposal by Senator Blanche Lincoln, an Arkansas Democrat who is chairman of the Senate Agriculture Committee, would have banned all swaps-trading by commercial banks.

It touched off intense lobbying from opponents including the banking industry, banking regulators, the Obama Administration and lawmakers of both parties who said the proposal could drive up costs for businesses and send business to foreign lenders.

In the final hours of negotiations, Obama's financial overhaul specialists - Deputy Treasury Secretary Neal Wolin; Michael Barr, Treasury's assistant secretary for financial institutions; and Diana Farrell, the deputy director of the White House's National Economic Council - gathered at the Dirksen Senate Office Building while House and Senate members of the conference committee waited downstairs for a deal.

In the end all parties agreed banks will be able to maintain their trading operations so long as they are used to hedge risk or trade interest rate or foreign exchange swaps, a victory for banks that were on the verge of losing the desks entirely.

The proposal will force a fundamental shift in the industry, giving federally insured banks up to two years to send instruments such as uncleared credit default swaps off to a separately capitalised subsidiary.

"We target the riskiest players and ask more of them, as we should," Lincoln said.

Derivatives took a central role in the debate over Wall Street regulation after losing bets on swaps tied to mortgage-backed securities pushed New York-based insurer American International Group to the brink of bankruptcy in 2008.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.

Beyond the swaps-desk provision, the Senate legislation will push most over-the-counter derivatives through third-party clearing houses and on to regulated exchanges or similar electronic systems, a measure that will make it easier for the market and regulators to track the trades. It will mean higher margin costs on some transactions.

Regulators also will be required to impose heightened capital requirements on companies with large swaps positions, and would be given the authority to limit the number of contracts a single trader can hold.

Businesses that use derivatives to hedge risk from producing or consuming commodities, deemed "end users," will be exempt from the clearing requirements if the activities were being undertaken as a way to hedge legitimate business risk.

"There are some that want more restrictive language than I do and there are those who want to open up the barn door," Lincoln said. "I think we have reached a good compromise here."

- BLOOMBERG