One of the statutory mandates for the Financial Crisis Inquiry Commission (FCIC)—the 10-member bipartisan investigative body modeled after the 1932 Pecora Commission—is to examine the role played by “derivatives and unregulated financial products and practices, including credit default swaps” leading up to the financial meltdown.
In the FCIC’s inaugural public hearing last week, there seemed to be widespread agreement among Commissioners and witnesses about the dangers posed by the unregulated over-the-counter (OTC) derivatives market, and the need to move as much of this trading as possible to centralized clearinghouses and exchanges. But as Federal Deposit Insurance Corporation (FDIC) Chair Sheila Bair pointed out, it’s ultimately up to Congress to pass the necessary reforms: “I think this should be a very high priority for Congress. And there’s only so much regulators can do until that legislation is enacted.”
The FCIC—with its $8 million budget, its authority to subpoena witnesses and documents, and the collective wisdom and experience of its 10 Commissioners, including former Commodities Futures Trading Commission (CFTC) Chair Brooksley Born—has the potential to thoroughly investigate the relationship between OTC derivatives and the financial meltdown, and to formulate meaningful recommendations for regulating this market. Unfortunately, the FCIC’s final report won’t be released until December 2010, long after the Senate is scheduled to pass its version of legislation to overhaul the nation’s financial regulatory regime.
Nonetheless, we hope the Senate pays close attention to the
advice of the FCIC Commissioners, witnesses, and other experts who are sounding
the alarm about the potential loopholes in Congress’s proposal to regulate this
The End-User Exemption — A Potential Impediment to Reform
In a speech before the Atlantic Council last week, CFTC Chairman Gary Gensler explained how the big Wall Street banks could stand to benefit from one such loophole. He’s referring to the so-called “end-user exemption,” which is basically Congress’s attempt to recognize a distinction between 1) the end-users: non-financial sector companies, municipalities, and non-profits that use derivatives as a standard business practice to hedge against risk (e.g., an airline protecting itself against an unexpected rise in fuel prices), and 2) the big Wall Street swap dealers that often use derivatives such as credit default swaps as a means of high-risk speculation. Many end-users are concerned about having to comply with new requirements for derivative counterparties to post margin and collateral for their trades through central clearinghouses.
A recent report on derivatives reform by the Congressional Research Service describes what could be at stake if Congress passes a broad end-user exemption:
The Bank for International Settlements publishes data on counterparties in several OTC markets. As of June 2009, 34% of OTC contracts were between reporting dealers, 56% were between dealers and other financial institutions, and the remaining 10% involved dealers and nonfinancial entities.
Thus, nearly two-thirds of OTC derivatives involve an end user. If all end users are exempted from the requirement that OTC swaps be cleared, the market structure problems raised by AIG still remain. [Emphasis POGO’s]
And as Chairman Gensler explained, it’s actually the big Wall Street dealers, not the end-users, that benefit most from keeping OTC derivative trades in the dark:
When a Wall Street bank enters into a bilateral derivative transaction with a customer, the bank knows how much its last customer paid for similar transactions, but that information is not generally made available to other customers or the public. The bank benefits from internalizing this information....
As a driver can best decide which gas to buy based on public prices posted at each gas station, corporations could better decide how to manage the risks associated with their business if they knew how much others were paying to manage similar risks. As such, it is the Wall Street banks that benefit from the so-called “end-user exemption” from transparency, not the businesses that use derivatives.
Eventually, House Financial Services Committee Chairman
Barney Frank (D-MA) scaled
back the exemption in the House’s financial regulatory reform bill. But all
eyes are now on the Senate, where Banking Committee Chairman Chris Dodd (D-CT)
is under pressure to include
a similar exemption.
And Still Other Loopholes Remain
And this isn’t the only potential loophole that could make its way into the Senate’s OTC derivatives bill. Last month, POGO wrote to Congress raising concerns about a provision in the House’s bill that would allow OTC derivatives trading to occur on a new platform called an “Alternative Swap Execution Facility.”
The best way to achieve the transparency that Chairman Gensler and others are calling for is to move OTC derivatives trading to well-regulated exchanges, which are required under the existing law to “make public daily information on settlement prices, volume, open interest, and opening and closing ranges for actively traded contracts on the contract market.”
But under the House’s definition of an Alternative Swap Execution Facility, there’s no requirement for trading to happen under a regulated exchange; in fact, the Facility can simply be any “person or entity that facilitates the execution or trading of swaps....including any electronic trade execution or voice brokerage facility” (i.e., over the telephone). It would then be up to the regulators to decide how much information to disclose about these transactions. The bill even appears to instruct the regulators to err on the side of secrecy: “The Commission shall evaluate the impact of public disclosure on market liquidity in the relevant market, and shall seek to avoid public disclosure of information in a manner that would significantly reduce market liquidity.”
Once again, it’s the big Wall Street dealers that are fighting hard to maintain this loophole, since greater price disclosure will reduce their profits. One analyst has estimated that JP Morgan alone stands to lose some $3 billion if derivative trades are moved to exchanges. As Stanford finance professor Darrell Duffie put it to The Wall Street Journal, “exchanges are anathema to the dealers.”
But rather than kowtowing to the big banks on this issue, we hope the Senate heeds the advice of the officials and experts who are trying to prevent another financial crisis. Again, the best way to inject a much-needed dose of transparency into the OTC derivatives market is to close the loopholes in the House’s bill and move as much trading as possible onto well-regulated clearinghouses and exchanges.
To learn more about this issue, be sure to check out POGO’s podcast on derivatives reform.
-- Michael Smallberg