Forbes: How Lobbyists And GOP Are Defusing Derivatives Regulation

This is the sixth in an 11-part series on the failed promises of the Dodd-Frank financial reform package and the continued, dangerous imbalances in our financial system.

I have always liked Warren Buffett’s succinct definition of derivatives — “financial weapons of mass destruction” — but, just to be clear, derivatives are called that because their price is derived from underlying assets such as stocks, bonds, commodities, or just about anything else. They can also be derived from entities that have no intrinsic value at all, including things like interest rates or an index. There are more types of derivative transactions than any one human being could imagine—swaps, caps, collars, forwards, etc. Plus combinations of any or all of them. Got it?
Fortunately, we can discuss derivatives without knowing exactly how they work, just as we can talk about hydrogen bombs without understanding the physics of fusion or fission. Not to belabor the analogy, but when either goes off, the results are guaranteed to be spectacular.
It was speculation in derivatives based on residential mortgages–Mortgage-Backed Securities and Credit Default Obligations– that brought down Bear Stearns, Lehman Brothers, crippled AIG and required American taxpayers to bail out the banks that were deemed too big to fail.
In its January 2011 majority report, the Financial Crisis Inquiry Commission wrote, “The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter derivatives was a key turning point in the march toward the financial crisis.”
Had hundreds of billions of dollars worth of AAA-rated CDOs not lost most of their value in a matter of days, there would have been no crisis.
Enter Dodd-Frank. The bill’s supporters made a lot of promises about reforming derivative trading. The summary issued after the bill passed included this statement about what it supposedly did:
“Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated — including loopholes for over-the-counter derivatives…”
Of course the bill itself did no such thing. It simply gave some vague guidelines to the regulators who would actually formulate new rules. The most important regulator of derivatives trading is the Commodities Futures Trading Commission. Early efforts there started off in the right direction. In fact, CFTC Chair Gary Gensler initially supported making all bids for derivatives contracts public. But Wall Street banks unleashed their lobbyists and by the morning of the CFTC vote, the requirement had been reduced to require dealers to obtain votes from only five banks before executing a contract. Even that was watered down after more pressure from Wall Street; the final rule requires only two bids.
To call this transparency is ludicrous. With only two bidders revealed, gaming the system is as easy as it is inevitable.As CFTC Commissioner Bart Chilton said, “By failing to act, we leave in place unregulated dark markets. These are the very dark markets that got us into the economic mess in 2008.” Dennis Kelleher, president of the think tank Better Markets, said banks opposed the requirement for more price quotes “to prevent a level playing field, competition and transparency.”
The Securities Exchange Commission isn’t doing any better than the CFTC. The SEC voted to exempt foreign subsidiaries of U.S. banks and foreign banks dealing with U.S. companies from Dodd-Frank rules. SEC Chair Mary Jo White explained the decision this way: “We should take a robust and workable approach to this particularly complex and predominantly global market. The global nature of this market means that participants may be subject to requirements in multiple countries, and this type of overlapping regulatory oversight could lead to conflicting or costly duplicative regulatory requirements.”
You might think that makes sense until you realize what a gigantic loophole the decision creates. It will continue to exempt from U.S. regulation much of the derivatives trading that was such a large factor in the financial meltdown. It means that there will be no U.S. regulation of trading such as the recent “London Whale” debacle that cost JPMorgan Chase over $6 billion.
As bad as things are at the SEC and the CFTC, they are worse is in the House of Representatives. As Eric Lipton and Ben Protess reported last month in The New York Times, “Bank lobbyists are not leaving it to lawmakers to draft legislation that softens financial regulations. Instead, the lobbyists are helping to write it themselves…One bill that sailed through the House Financial Services Committee this month–over the objections of the Treasury Department–was essentially Citigroup’s, according to e-mails reviewed by The New York Times. The bill would exempt broad swathes of trades from new regulation…In a sign of Wall Street’s resurgent influence in Washington, Citigroup’s recommendations were reflected in more than 70 lines of the House committee’s 85-line bill. Two crucial paragraphs, prepared by Citigroup in conjunction with other Wall Street banks, were copied nearly word for word. (Lawmakers changed two words to make them plural.)”
The House has already passed a number of bank-sponsored bills including the Swap Jurisdiction Certainty Act, which would codify into law the SEC proposal to exempt foreign subsidiaries of U.S. banks from U.S. rules on the trading of derivatives.
To make matters worse, New York Senators Schumer and Gillibrand, along with four Senate colleagues, have written Treasury Secretary Lew asking him to persuade the regulators to allow the big New York banks to avoid U.S. regulation by trading derivatives through their foreign subsidiaries.

In the last quarter of 2012 U.S. banks and savings institutions held $223 trillion in derivatives–fifteen times our GDP. Our four largest banks hold 93 percent of those derivatives. Given how easy it is for banks to transfer trading activities to any office they choose, the foreign subsidy loophole effectively means there will be no U.S. regulation of this gigantic, nontransparent market.
On July11, there were press reports that the CFTC, led by Chairman Gary Gensler, was actually going to close the loophole and include foreign subsidies under their regulatory authority. But the next day, under pressure from Secretary Lew and some members of Congress, the CFTC decided to hold the loophole open at least until December 21.
So much for the Dodd Frank promise: “Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated — including loopholes for over-the-counter derivatives…”

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This article is available online at:
http://www.forbes.com/sites/tedkaufman/2013/07/24/how-lobbyists-and-gop-are-defusing-derivatives-regulation/