More Delay on Derivatives

| Mon Mar. 15, 2010 3:45 PM EDT

The big omission in Sen. Chris Dodd's long-awaited financial reform bill today is any substantive update on new regulation of derivatives, those tricky, opaque financial products that have caused such immense headaches. Derivatives, in a nutshell, are contracts whose value goes up or down based the price of an underlying entity, like a stock, bond, certain form of currency, or commodity (corn, oil, etc.). Right now, most derivatives are traded "over-the-counter," which means the trade takes place between a customer and a broker-dealer, and there's little to no information published about trading, so hundreds of billions of dollars in derivatives trades essentially take place in the dark.

What lawmakers and reforms want to do is move most of those trades onto a clearinghouse or exchange like the New York Stock Exchange. That would shed some light on who's trading with whom, how much the buyer bought, and how much the buyer paid. Sounds fair, right? The House's financial reform bill called for moving OTC derivatives trading onto exchanges, and Dodd's initial framework for financial reform released in November called for the same. However, negotiations between Sens. Jack Reed (D-RI) and Judd Gregg (R-NH), the two lawmakers tasked with crafting the Senate banking committee's derivatives overhaul, have yet to result in any new breakthrough, and the derivatives language in Dodd's plan announced today offers no new updates on where those negotiations might be headed.

Going forward, the key aspect of derivatives reform to watch is whether some senator throws in what's called an end-user loophole. End users are the companies—airline companies, utilities—who use derivatives for legitimate purposes, like hedging the price of oil so that if oil costs go up or down, those companies can plan on a consistent price level. It's basic risk management. Some lawmakers want to exempt these endusers because they're not using derivatives for speculative, gambling purposes. The problem is, an enduser loophole would ultimately exempt two-thirds of OTC derivatives trades—and a number of those exempted would trades by gambling banks, letting the people who need to be regulated slip by. It would be the exception that ate the rule, and it's a crucial part of the bill. How Sens. Reed and Gregg deal with it will be a telling sign of how serious they are about reining in these troublesome trades.