Derivatives Reform, 5/20: The Two Loopholes That the Fight is Over

This derivatives fight also occurred in the House, which we will discuss at the end of this entry. But first David Dayen (who you should read for the hour by hour breakdown of this bill moving) has the recap of how derivatives reform stopped the vote for cloture:

As I noted earlier, this is basically the loophole that Americans for Financial Reform has suggested would make the mandate of trading derivatives on clearinghouses meaningless, because there would be no penalty or force behind it, and it would not disallow uncleared swaps. Some have called this a made-up problem, saying that the penalties do exist for violating the derivatives statute on clearinghouses. But Cantwell obviously doesn’t think so.

Cantwell’s two-page amendment, co-sponsored with Blanche Lincoln, would clarify the language. It says that “any swap that is required to be cleared is unlawful unless the swap is cleared.” The current language is looser. The other part of the amendment allows regulators to stop derivatives deals if banks violated trading requirements. Basically it amounts to loophole-tightening, and the argument that it’s not important because the language is already tight makes little sense. Because if the end goal is to have language that works, what’s the problem with clarifying it?

We discussed two potential derivatives loopholes in the bill (One, Two), the first being about what constitutes a trading facility, and the second is what are the consequences for a derivative that doesn’t follow the rules. This fight is over the second one. Cantwell has also introduced an amendment to tackle the first, but it looks unlikely that it will be up for a vote.

Over the weekend, Shahien Nasiripour had a writeup of this second derivatives loophole issue. Inside the second derivatives loophole issue is two issues, one being the penalties for not trading on a clearinghouse and the second being what if a clearinghouse turns down a derivative:

Furthermore, the email points out, even though federal regulators may require that a swap be cleared, they can’t mandate a clearinghouse to accept it.

Parties wanting to enter into a typical derivatives contract usually go through a middleman called a Futures Commission Merchant (FCM). The entities will then take the contract and submit it to a clearinghouse. These merchants have the authority to reject contracts.

The biggest futures commission merchants are owned by the largest banks, according to data collected by the CFTC. The largest banks also act as the dealers of derivatives. The big banks dominate the market. They also stand to lose the most revenue because of the increased transparency.

Let’s say you wanted to keep a derivative that has been flagged for clearing in the “dark”, off the grid of clearing and swap execution facilities. One way is to simply not put it through the clearinghouse. There are penalties for doing this if the CFTC wants to enforce it. Why not make those explicit, and allow market players more clear right in the law? You’d be sure it would get enforced if these rights were broadly distributed rather than through the coin toss of who is running the government that year.

The second way to keep it dark is to simply have the clearinghouse you own not accept the contract. If you are one of the major broker dealers, chances are you also have power over the private financial institutions and infrastructure that would be responsible for carrying out these derivatives reform. Keeping the clearinghouses from accepting a large part of the derivatives on the back-end will create a de facto major exemption, and everyone can shrug and say “hey well ‘the market’ decided against taking these derivatives out of the dark into clearing, what can we do?”

The problem comes back to the major dealer banks ownership of the largest derivatives infrastructure, an issue flagged by Bob Litan’s recent Brooking Paper: “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties.”

Not a New Problem

This isn’t a new problem for serious derivatives reform, and effort was put in last fall to come up with a way to fight it in the House Bill. The House decided to tackle this specific issue through passing the Lynch Amendment, a problem and approach for a solution which I wrote last fall up here, which clarified:

(B) BENEFICIAL OWNERSHIP BY A RESTRICTED OWNER – The rules of a clearing agency that clears security-based swaps shall provide that a restricted owner shall not be permitted directly or indirectly to acquire beneficial ownership of interest in the agency or in persons with a controlling interest in the agency, to the extent that such an acquisition would result in restricted owners controlling more than 20 percent of the votes entitled to be cast on any matter by the holders of the ownership interests.

This is meant to break the concentration of the clearing agencies so that any one agent can’t control more than 20% of the agency. However, as far as I understand, the current concentrated ownership structure is grandfathered and protected under the bill. The other way is what Cantwell is holding up cloture for, and it is a discussion that is much needed.

Remember derivatives reform is resolution authority reform, and having one without the other weakens both.

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3 Responses to Derivatives Reform, 5/20: The Two Loopholes That the Fight is Over

  1. Pingback: Morning Must Reads: Hazard - Swampland -

  2. Dr. Goose says:

    Said Obama: “For all of our betterment,
    Derivatives need clearinghouse settlement,
    But the five biggest banks
    Are circling their tanks,
    A politically potent impediment.”

  3. Pingback: Sen. Cantwell’s Courageous Vote « SpeakEasy

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