How to Kill OTC Derivatives Reform in Two Sentences

I’ve written a post at Baseline Scenario that you should read, and if you think it is urgent, which I hope you do, I encourage you to forward/link/etc.

We all knew some loophole was going to sneak in at the last minute, and that it’s our job to find it and stop it. I think we found this one, now it’s a matter of getting staffers and legislators to act to make sure they can deliver the reforms promised.

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13 Responses to How to Kill OTC Derivatives Reform in Two Sentences

  1. Ted K says:

    On finance issues (and maybe even economic issues in general) you have shown yourself to be the King of bloggers Mike Konczal (James Kwak gets 2nd). Congrats on your well deserved entrance to the Roosevelt Institute!! Please make sure that your views at Roosevelt are very accessible to the common man. We out here are so thankful for your blogging and that you make stellar information and analysis free to the common working man out here. Your post at “Baselinescenario” today cannot be complimented and cheered enough. We are grateful, and WE LOVE YOU MIKE KONCZAL!!!!!!! (now keep digging in these law drafts and don’t get a big head)

  2. economicsofcontempt says:

    Sigh. You still haven’t even attempted to explain WHY mandatory exchange-trading offers any benefit at all over and above “clearinghouses + disclosure requirements (+ alternative swap execution facility).”

    I know you know that exchange-trading offers the exact same systemic risk mitigation as clearinghouses + disclosure requirements, and that the only difference is the trade execution venue. Claiming that the exchange-trading requirement is a “loophole” that will “kill OTC derivatives reform” is disingenuous at best — really, it’s borderline dishonest.

    This is why I find the current financial reform debate so discouraging. It’s no different than when Republicans hype some minor, largely cosmetic issue in the health care bill, and shout about how “this must not stand!” It’s incredibly frustrating when they do that, right? Well, just remember that you’re doing the same thing right now.

    You say you want to have a serious discussion on OTC derivatives reform. This is not it.

    • Ted K says:

      Disclosure requirements don’t work and won’t work. There are too many ways for big banks (or other financial institutions) to side-step and evade if the swaps/derivatives are not on a registered exchange. YOU sir are the insincere liar.

      • economicsofcontempt says:

        Oy. Exchanges are subject to disclosure requirements too, chief. The exchanges all own clearinghouses that clear their trades, and this centralization of an exchange’s trades in its clearinghouse is the only reason that exchanges are able to disclose daily volume, open interest, etc., in the first place. So putting standardized OTC derivatives on clearinghouses (which are every bit as “registered” as “registered exchanges,” by the way) would allow regulators to impose disclosure requirements that are exactly as effective as the disclosure requirements for exchanges.

        See Mike, this is what I mean. Now we have people who are convinced that requiring clearinghouses + regular disclosure requirements (+ alternative swap execution facility) is tantamount to leaving OTC derivatives unregulated — even though that’s flatly untrue, as you well know. And it’s not even in the service of a greater good either, because requiring exchange-trading rather than just clearinghouses is a terrible idea, which can’t stand on its own merits.

    • Not the Mike You're Looking For says:


      Would you mind explaining yourself a little further, or at least pointing me to a resource that explains the issues I’m about to raise?

      As I understand it, the distinction between an exchange (as defined in the bill) and a clearinghouse is the long-term, formal relationships that underlay the latter. More specifically, the obligations of clearinghouse members are guaranteed collectively by all members of the clearinghouse. This not only makes the obligations more secure, but it gives members an incentive to police the risk of other members, most likely through an appointed committee.

      The bill, on the other hand, sounds like it is authorizing bilateral exchanges through its broad definition of “exchange.” That would mean that the obligations of the parties would be backed up only by their own assets, and the only policing mechanism would be caveat emptor, which failed to stop so many firms from insuring their credit default swaps with AIG.

      Have I got something wrong?

      • Ted K says:

        I think we’ve already seen how good they “police” each other through these clearinghouses. They say “fuck it, if things go bad we can get the U.S. taxpayer to pay for it” and guys like Joe Cassano run off to a posh neighborhood in London with millions. Those are the clearinghouses EOC is referring to.

  3. Russ says:

    We don’t need OTC derivatives at all. They serve no purpose. Commodity speculation of course should not be allowed to exist at all. It is purely destructive, delinquent, antisocial behavior.

    Registered exchanges can serve all legitimate hedging needs on the part of those who actually deliver or take delivery to use the commodity.

    That’s the only thing that should even be on the table.

  4. Norm says:

    Clearinghouses and exchanges are not the same. At all. If it helps, think about it like this: The exchange is eBay, and the clearinghouse is PayPal. As with eBay/Paypal, they are often owned by the same company, for efficiency and operational reasons. (CME, Eurex, NYSE Liffe, ICE, etc.) But not always: LCH.Clearnet is a clearinghouse only. All exchanges are cleared, because the contracts are liquid, standardized and the pricing is transparent. Many standardized OTC markets are cleared too: LCH.Clearnet clears nearly all OTC interest rate swaps.

    Customized OTC instruments can’t be traded on an exchange, because there’s insufficient demand/liquidity. They also cannot be cleared, because the clearinghouse needs a price in order to margin the counterparties.

    It’s a little surprising that Rortybomb (apparently) doesn’t understand the distinction between clearing and exchanges. It makes me wonder how well he actually understands the overall issue.

    It’s pretty clear that economicsofcontempt does. And so does Craig Pirrong over at, though he comes at the issue from a different ideological perspective.

    • Not the Mike You're Looking For says:

      OK, wait. Doesn’t the alleged loophole in the bill permit people to trade outside of both exchanges AND clearinghouses? Put differently, does the amendment/bill state anywhere that trades on these “alternative” exchanges MUST clear through an approved third-party intermediary?

      To use the eBay/PayPal example, the amendment sounds like it’s saying that for certain types of trades, the parties can disregard both firms. One of them just has to declare itself an “exchange,” and the two can make a bilateral transaction.

      • Ted K says:

        Clearinghouses add zero transparency. Read the paper by Darrell Duffie and Haoxiang Zhu of Stanford University here This is why registered exchanges are necessary. You cannot regulate what you can’t see. And counting/depending on counterparties to control systemic risk is like handing over your personal bank account to Bernie Madoff. Or more accurately handing over ALL of the national banking system’s reserves to AIG and Bear Stearns and saying “Here, see what you can do with this”. I wouldn’t advise it.

      • economicsofcontempt says:

        “Doesn’t the alleged loophole in the bill permit people to trade outside of both exchanges AND clearinghouses?”

        No! Absolutely not! The bill still requires clearinghouses, and none of the amendments do anything to change that. Clearinghouses are a done deal. The only issue is whether IN ADDITION TO requiring central clearing, standardized OTC derivatives will ALSO be required to be executed on exchanges (i.e., boards of trade). That’s why this is such an over-hyped, nonsense issue. Exchanges only mitigate the systemic risk of OTC derivatives because they clear their trades through their clearinghouses. In other words, it’s not the *exchange* that’s mitigating the systemic risk, it’s the exchange’s *clearinghouse* — the exchange is just the trade execution venue.

        But there are lots of trade execution venues OTHER than exchanges (e.g., ECNs), and different trade execution venues are better for different instruments. But as long as the financial reform bill requires that all standardized OTC derivatives be cleared on registered clearinghouses — which the House bill does — then the systemic risk of OTC derivatives has been mitigated regardless of whether exchange-trading is required. The Peterson/Frank amendment only affects the trade execution venue (it effectively levels the playing field b/w the exchanges and the alternative trading systems) — it does NOT change the clearinghouse requirement. That’s why this post is so disingenuous and misleading.

      • Not the Mike You're Looking For says:

        Thank you for clarifying. The underlying issue is more apparent now.

  5. Mike says:


    I do not claim that these amendments would prevent trades from clearing at any point.

    Barney Frank has openly declared that he wants exchange-trading required driven reform. Everyone knew this was going to be fought by industry with force. Your own phrasing was that Franks’ requirement “sandbagged the dealers”. It’s been challenged both by exemptions to the exchange, and by attacking the legal definition of an exchange. As such, if an amendment sneaks in that looks to undo what Barney Frank and other committee regulators are hoping the legislation will accomplish, it’s important that it is caught and, at the very least, clarified. If lawyers associated with the government tell me that this language is harmless to having exchange-driven reform, then we are good. Or if Frank is backing away from exchange-driven reform, which I don’t believe he is, he should clarify that in public.

    I know you think that the exchange-driven reforms are a bad idea. I’ve given a partial answer here as to my thoughts on why it is a good idea. If you want to make that case, please do, but understand that it comes before what is going on here – how to make this proposal into law without loopholes, not whether the proposal is what you think is a good idea.

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