Derivatives Update 5/14: SAFER and A Loophole Fix?

SAFER Keeps Up the Fight

SAFER has put out a letter responding to Bernanke on Section 716, which is the Section 106 fight.

And Joe Stiglitz lays out his case defending Section 716 in a 5 page letter located here. You should read both because they are the strongest defenses of this language that reformers have produced to answer the last round of critiques from the administration. Here’s a quote from Stiglitz’s letter:

So long as those financial institutions that have access to federal assistance (or are likely to have access in the event of a crisis) can write such contracts, the government is effectively underwriting these con-tracts. The market gets distorted in two ways: first, these institutions have a competitive advantage, not based on greater efficiency, but based on more likely access to government assistance. Second, the insurance is underpriced, because it is effectively subsidized (or, when these instruments are effectively used as gambling instrument, gambling though these instruments is encouraged). Subsidies, whether explicit or implicit, distort resource allocations and contribute to a less efficient economy. There are certain instances where the government might want to encourage certain economic activities, but those should be clearly articulated and narrowly circumscribed. I see no compelling reason why the U.S. gov-ernment should be engaged in subsidizing credit default swaps or derivatives, whether they are viewed as risk management products or gambling instruments. On the contrary, to the extent that these prod-ucts have shown that they can increase societal risk, with huge costs, these have demonstrable negative externalities, and a compelling case could be made for taxing them. The amendment does not go that far. It takes a far more modest step of ending the implicit subsidy….

It is important to realize that restricting the too-big-to-fail banks from engaging in certain activities does not mean that these services will not be provided—though without the implicit subsidies, the extent to which they are used may be reduced. No evidence has been presented that there are sufficient economies of scope to offset the systemic risk to which current arrangements give rise. (And as we have noted, the fear that these activities will move to less well regulated has little merit.)…

In short, I urge you to defend the strict derivatives regulation language in the Senate Bill, including the important Section 716.

Potential Derivatives Loophole #1 Amendment Fix

Two weeks ago we discussed Potential Derivative Loophole #1: Trading Facility, where a swap execution facility no longer means a “trading facility” but just a “facility.” Though just a one word deletion, it had the potential to radically change the function of the bill.

According to Bloomberg Business, there’s now an amendment to fix this loophole. Senate Amendment Would Again Take Phones Out of Swap Trading:

Senators Tom Harkin and Maria Cantwell introduced an amendment to the financial reform bill to ensure electronic trading, not phone transactions, are used to buy and sell most swaps after the legislation was changed last month….

In late April, a one-word deletion was made to the 1,565- page Senate financial reform bill that could help banks and inter-dealer brokers maintain phone trading in the unregulated market. The word “trading” was deleted from the term “trading facility,” which could have been interpreted to refer to the same term in the Commodity Exchange Act.

Harkin and Cantwell’s amended definition of swap execution facility is very similar to language introduced earlier this year by Senator Christopher Dodd, chairman of the Senate Banking Committee and a Democrat from Connecticut. The part of his bill dealing with derivatives was replaced by a version written by Sen. Blanche Lincoln, chairman of the Senate Agriculture Committee and a Democrat from Arkansas.

Fantastic. Keep an eye on the analysis of this. I’m curious as to how much of a fight there will be over it.

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