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Keeping Loopholes Out of Derivatives Reform

SOURCE: AP/Harry Hamburg

A conference committee is now reconciling a Wall Street reform bill that includes language from Sen. Blanche Lincoln (D-AK) that will regulate derivatives trading.

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The conference committee reconciling the House and Senate’s respective Wall Street reform bills got down to business this week, starting with the Senate’s text as its base. This is a good thing when it comes to crafting a regulatory regime for derivatives—the risky instruments that played a large role in the economic crisis, and particularly in the downfall of AIG—because the Senate language, authored by Sen. Blanche Lincoln (D-AR), is much stronger.

Derivatives are contracts between two parties that are linked to the price of another financial instrument or a specific condition or event. (Think of them as a cross between an insurance policy and a bet.) Companies use derivatives to hedge against changing markets. For instance, an airline would purchase derivatives to protect itself from an increase in the price of jet fuel. The company would essentially “bet” that the price of jet fuel increases, thus receiving a payout if such an increase occurs.

But financial services companies also use derivatives to speculate. And a lack of regulation and information regarding this opaque market during the buildup to the financial crisis led financial behemoths to offer far more of them than they could honor—especially in the form of credit default swaps.

As CAP Associate Director for Financial Markets Policy David Min and I wrote, “American International Group’s inability to honor their many billions of dollars in credit default swap derivative obligations caused investors to question the value of the many financial instruments tied to credit default swaps, causing a classic ‘run on the bank’ situation for the unregulated parts of the financial system.”

Strong derivatives reform will place all standardized derivatives trading onto public exchanges—like those used for stocks and futures. And it will force all customized trades that can’t go onto an exchange through a clearinghouse, which ensures that both sides of the trade have adequate collateral. This will ensure that market prices are available for all market participants and give regulators a clear path to follow as they seek to police fraud and abuse.

The trouble with the House bill is that it contains a host of exemptions to the exchange and clearing requirements, which could allow financial companies that are only using derivatives for speculation to slip through unregulated. Depending on how the language is read, it could even exempt transactions between two financial companies outright.

Commodity Futures Trading Commission Chairman Gary Gensler—who has been instrumental in pushing lawmakers to implement strong derivatives reform—has warned that exemptions will allow financial companies to fall back into the unregulated parts of the market, endangering financial stability:

“Every exemption for financial companies creates a link in the chain between a dealer’s failure and a taxpayer bailout. Every slice of the financial system that we cut out through an exemption could allow one bank’s failure to spread like fire throughout the economy. It is essential that financial reform does not allow loopholes that leave interconnectedness in the system. Such exemptions will only come back to haunt us in the future.”

Lawmakers are legitimately concerned that the use of exchanges and clearinghouses will push up costs for companies already reeling from the lack of demand that has come in the wake of the Great Recession. But clear and consistent regulation of derivatives should help these companies, since transparent markets lead to lower prices. If derivatives dealers are forced to compete for business with each other—unlike the current environment, which makes price comparison all but impossible—companies will be able to shop for the best deal.

One provision of Lincoln’s Senate bill that has gotten more attention than any other is Section 716, which would force banks to house their derivatives trading desks in a separately capitalized entity. The aim is to prevent banks from using federally insured dollars to engage in risky derivatives trading for their own benefit. Initial reporting on Section 716 portrayed it as requiring banks to get out of the derivatives business entirely, but Lincoln has since clarified that a derivatives desk can remain under a bank’s umbrella (in a subsidiary or affiliate), as long as it is independently funded.

Such a step does have its advantages. For starters, the federal government should not be backstopping risky trading that only benefits the banks involved. As Kansas City Federal Reserve President Thomas Hoenig and Dallas Federal Reserve President Richard Fisher wrote in a letter supporting Section 716, the risks associated with these activities “are generally inconsistent with the funding subsidy afforded institutions backed by a public safety net. Such activities should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk.”

Roosevelt Institute Senior Fellow Mike Konczal has also pointed out that forcing banks to become consumers of derivatives when they need to legitimately hedge risk will make them more interested in having a transparent, functional marketplace with low prices. “As the major banks would participate in the market as a consumer of derivative products for their own hedging needs, their size and power would be redirected to serve as a first line of market discipline on the dealers,” he wrote.

There has been considerable opposition to Section 716 on the part of the Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corporation. But former Federal Reserve Chairman and current Obama administration adviser Paul Volcker this week softened his initial criticism of the measure, thus boosting its chances of remaining in the final legislation. “It may be useful in some cases to have particular activities separated out,” he said.

It is absolutely critical that derivatives reform bring this opaque market into the light and establish clear rules of the road that derivatives dealers and traders must follow. Every exemption and carve-out that allows a portion of the market to remain in the dark will be to the detriment of financial stability.

Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.

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