While Treasury secretary Timothy Geithner's testimony on Friday shed little new light on how the administration plans to regulate the financial derivatives markets, a bill introduced in the Senate earlier in the week by Sens. Dianne Feinstein (D-Calif.) and Olympia Snowe (R-Maine) may have set a gold standard against which to judge the administration's efforts going forward.

The bi-partisan Carbon Markets Oversight Act of 2009 creates a regulatory framework for the carbon markets that would ensure their long term stability, transparency and efficiency by: 1) creating a central oversight authority for carbon trading, 2) limiting over-the-counter (OTC) trading to commercial users, and 3) requiring the bulk of trading to take place over registered exhanges. 

Central Oversight Authority

The Carbon Markets Oversight Act creates an Office of Carbon Market Oversight under the CFTC that would establish standards for all participants in the US carbon markets including traders, exchanges (both domestic and international), clearer's, and administrators. This approach is preferable to  simply adding carbon oversight to an existing regulatory provision as a new independent regulator would have the freedom to design protections that specifically address the needs of the carbon markets as the evolve over time.                      

Limited OTC Trading

Unlike in the House climate bill, where over-the-counter trading is effectively banned, the Feinstein-Snowe climate bill permits commercial participants to enter into OTC or bi-lateral contracts. These bi-lateral contracts can only be entered into, however, if it can be demonstrated that such transactions are: 1) unique, 2) not significant relative to the size of the derivatives market, and 3) not settled against or referenced to the price of an applicable transaction. In other words, OTC trading will be limited to small, commercially driven transactions that will have little impact on the broader carbon markets. 

Exchange Driven Trading

Carbon derivatives will primarily be transacted and cleared through registered carbon allowance derivative exchanges. Participants in the carbon markets will be required to: 1) adhere to meaningful speculative position limits that would be monitored on a real time basis, 2) serve jail time or pay heavy fines for acts of market manipulation and fraud, 3) undergo testing, and meet eligibility requirements, 4) transact through a central limit order book to facilitate best execution of trades, and 5) pay fees through the trading facilities to fund the oversight functions of the regulator.

In sum, Senators Feinstein and Snowe should be applauded for providing the market assurances needed to create a viable carbon market under climate legislation. By centralizing oversight and keeping the overwhelming majority of trades on exchanges, the bill would ensure that carbon trading takes place in full view of the market regulator, reducing speculative activity and counter-party risks which tends to thrive in the shadows. While more can be done to ensure that the bill is strengthened and other energy markets follow suit, the Carbon Markets Oversight Act of 2009 deserves to be held up as a new benchmark for derivatives regulation.