Market participants are increasingly concerned about provisions in Senate and House regulatory reform bills that are designed to address the level of sophistication of states and localities that want to engage in over-the-counter derivatives transactions.

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The worries have come to the forefront as the Senate Banking Committee is expected to begin marking up its proposed 1,139-page bill sponsored by chairman Christopher Dodd, D-Conn, sometime next month. Meanwhile, the full House is expected to vote on several measures pushed by Financial Services Committee chairman Barney Frank, D-Mass., in mid-December that may be combined into a single omnibus bill, congressional sources said.

At a Banking Committee hearing last week, several senators said they were unhappy with various provisions in their draft bill, but its muni provisions did not appear to be the subject of their concerns.

Specifically, the Senate bill would prohibit states and localities that have discretionary investments of less than $50 million, excluding bond proceeds, from being considered “eligible contract participants” in derivatives transactions. Derivatives deals with non-ECPs must be exchange-traded, which may not be feasible for state and local governments because they would be required to meet daily margining requirements.

The House bill contains a similar provision that states and localities would not be ECPs unless they have $50 million of discretionary investments. But under that bill, they could be ECPs if their counterparty is a bank or broker-dealer, which would mean that virtually all municipalities could engage in derivatives transactions.

Peter Shapiro, managing director at Swap Financial Group in South Orange, N.J., said the $50 million threshold “seems like a strange standard” to gauge sophistication. Instead, the threshold should be based on the size of an issuer’s debt portfolio, perhaps $50 million of outstanding debt.

“How much they have to invest on the asset side of their portfolio has very little to do with how sophisticated they would be at managing derivatives on the debt side, which is where governmental agencies use derivatives overwhelmingly,” Shapiro said. “There are very sophisticated agencies that don’t manage assets.”

One such agency, the New Jersey Educational Facilities Authority, has about $5 billion of outstanding debt and about $1 billion invested in bond funds, but only about $10 million of what might be considered “discretionary assets,” said Roger Anderson, the NJEFA’s executive director.

“We think we’re very sophisticated, but we’re small,” said Anderson. He added that basing the $50 million threshold on the amount of bonds outstanding would speak to some sophistication, though he believes a better metric would be to simply impose a suitability requirement on muni issuers’ counterparties.

Sam Gruer, managing director at Cityview Capital Solutions LLC in Millburn, N.J., said the legislation should focus less on a numerical threshold and instead base an issuer’s eligibility on whether it has a full-time chief financial officer, the background and education of its staff, and the number of times it enters the market in a year.

“An issuer that’s frequently accessing the market is probably more in touch with what’s going on in the market than someone who issues bonds once every two years,” Gruer said.

Market participants also are concerned about a separate provision in the Senate bill that would require an issuer to hire an independent swap adviser and for its dealer counterparty to have “a reasonable basis” to believe that the adviser has expertise and will make disclosures to the issuer about fair pricing and the appropriateness of the transaction.

While requiring issuers to hire swap advisers would essentially mandate existing practice, Anderson said he resents the idea of requiring swap dealers to essentially sign off on the competency of the swap advisers that issuer hires, because it presumes municipal governments are never sophisticated.

Scott DeFife, senior managing director for government affairs at the Securities Industry and Financial Markets Association, was more pointed. He said the provision “doesn’t make any sense,” largely because both the House and Senate bills would require all FAs to be registered with the Securities and Exchange Commission and to follow either Municipal Securities Rulemaking Board or SEC rules.

As a result, DeFife said that it seems “onerous and duplicative and paternalistic” to “propose that a municipal government can’t make its own well-reasoned determination of the type of swap adviser to hire ... as a competent, independent custodian of its swap management.”