Financial Reform Bill, Part 3

Posted in Financial Markets, Politics and Policy at 6:01 pm

In this post I’ll address Section 4, entitled, “Transparency & Accountability for Exotic Instruments” AKA Derivatives Reform.

From the summary:

Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated – including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Odd that the last three – hedge funds, mortgage brokers, and payday lenders were lumped in with derivatives.

Here are the details:

Bringing Transparency and Accountability to the Derivatives Market

Closes Regulatory Gaps: Provides the SEC and CFTC with authority to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight.

The devil will again, be in the details. I’ll just note that it was the Commodities Futures Modernization Act that explicitly exempted certain financial derivatives, including Credit Default Swaps, from regulation. This wasn’t a case of an alternative unregulated market organically growing alongside a regulated one, it was the result of a conscious decision by the regulators to explicitly not regulate these instruments.

Central Clearing and Exchange Trading: Requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. Requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.

First, let me state that requiring derivatives to be traded through a clearinghouse is absolutely a positive development.

However, throughout the debate, there has been considerable confusion between the roles of clearinghouses versus exchanges, with many, inside and outside of government incorrectly using the terms interchangeably. A clearinghouse is a third party, sometimes owned by its members, that acts as a hub between parties in all transactions (as opposed to bilateral trading directly between market participants). This shifts counterparty risk directly to the clearinghouse, which attempts to resolve it through collateral requirements, regular marking of positions to market, and having all members be jointly responsible for any failures. An exchange is simply a mechanism for centralizing trades and making price and volume information publicly available. In practice, many existing exchanges have their own captive clearinghouse, but this need not be the case, and they are certainly synonymous.

Ultimately, moving trading to a clearinghouse prevents the emergence of another AIG which makes a lot of one way bets that it can never hope to payout on in the event it loses, exposing the entire system to collapse (and subtly causing the underpricing of risk by firms who mistakenly believed themselves to be covered in the event of default).

Market Transparency: Requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks.

No issue with this as described.

Regulates Foreign Exchange Transactions: Foreign exchange swaps will be regulated like all other Wall Street contracts. At $60 trillion, this is the second largest component of the swaps market and must be regulated.

Odd that they decided to call this out, given that they did not previously identify the swaps being discussed as Credit Default Swaps. And while they’re at it, why not mention interest rate swaps?

Increases Enforcement Authority to Punish Bad Behavior: Regulators will be given broad enforcement authority to punish bad actors that knowingly help clients defraud third parties or the public such as when Wall Street helped Greece use swaps to hide the true state of the country’s finances and doubles penalties for evading the clearing requirement.

Oh come one. Fraud is already illegal. And how do you “double penalties” for new legislation where the baseline penalties haven’t even yet been determined?

Higher standard of conduct: Establishes a code of conduct for all registered swap dealers and major swap participants when advising a swap entity. When acting as counterparties to a pension fund, endowment fund, or state or local government, dealers are to have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them.

Having codes of conduct is fine, but I’m sure most firms already have them. The second part seems to weaken the responsibility of dealers to the enumerated types of clients. We’ll have to wait for more details on that one.

Overall, requiring existing OTC dervivatives to be traded through clearinghouses is sound policy. The ultimate effect will be determined by the extent of the loopholes written into the law – the size of the remaining OTC market post-implementation.

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