NEW YORK (Reuters) - The Obama administration's plan to reshape murky derivatives trade threatens to slash liquidity and intensify price swings in commodities and energy markets if lawmakers don't tread lightly with the details.
Such an outcome would cut against the government's aim of stabilizing prices by stemming speculation and increasing transparency in the opaque world of derivatives, which billionaire investor Warren Buffett famously labeled "financial weapons of mass destruction" in 2003.
"It is hard to argue against transparency. This could be done with a light hand that doesn't really add much in the way of direct costs for anyone," said Tim Evans, energy analyst, Citi Futures Perspective in New York.
"But in the worst case scenario, it could be the end of trading life as we know it. There could be no liquidity in the markets, volatility could soar, price uncertainty could abound, and everyone could shift their positions to a new exchange yet to be opened in Sri Lanka," he said hypothetically.
Treasury Secretary Timothy Geithner called this week for legislation to require many derivatives to be traded on regulated exchanges or clearinghouses, rather than on unregulated over-the-counter markets. Experts are concerned that the legislation could eventually include wider-reaching elements, raising costs and constricting positions.
While the effort appears directed at the opaque credit derivatives swaps market -- blamed for worsening the financial crisis -- regulatory scrutiny of the commodities and energy markets has also intensified since oil prices struck a record near $150 a barrel last summer.
"In many respects, regulation of the OTC market creates an even playing field for all the individuals who are involved in the market, all the companies in the market," said Edward Morse, analyst at LCM Commodities in New York.
"Really the question is, what is the government going to do? Is it going to overextend its hand, is it going to make the market less workable, or is it going to move, as it may well, to make it more workable?"
Through over-the-counter commodities and energy markets, parties buy and sell physical oil and other commodities -- often priced against underlying futures prices determined by regulated exchanges such as the New York Mercantile Exchange.
These markets swelled during the five-year commodities boom, along with trade volumes on the regulated exchanges, with OTC trades at one point 120 percent bigger than those on futures markets, according to LCM's Morse.
Analysts said they expected the regulation to require significant data reporting that will increase transparency, but that it could also include more burdensome regulations limiting positions that can be held by large players.
"This is something that is going to have to be worked through the legislature and that could take a very long time," said Addison Armstrong, director of market research at Tradition Energy in Stamford, Connecticut. "It could emerge in any number of permutations from doing nothing to moving toward an extremely regulated environment."
Regulators "have to move carefully, because if they don't there is going to be a kind of regulatory arbitrage," said Greg Mocek, a former chief of law enforcement at the CFTC and now a partner at the Washington law firm McDermott Will and Emery.
But experts said any regulation that can improve transparency without being overly onerous would be welcomed by commodities and energy market players.
"It takes a market that was potentially maligned for all the wrong reasons -- or potentially all the right reasons -- and lets us find out how big an impact these are having on oil prices," said Peter Beutel, president of Cameron Hanover in New Canaan, Connecticut.
"From what I have seen there is an element of transparency that could be important for the marketplace," said Eric Kalamaras, head of energy research at Wachovia Securities in Charlotte, North Carolina.
Additional reporting Chris Doering, Joshua Schneyer, Rebekah Kebede, Janet McGurty, Alden Bentley; editing by Jim Marshall