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Is Obama Blowing It on Derivatives Reform?

The gaping loophole in the administration's new financial regs.

—By Nick Baumann

36 Comments | Post Comment

—White House photo.

Wed June 17, 2009 12:41 PM PST

On Wednesday, President Barack Obama released his proposal (PDF) for regulating the Wild West market of financial instruments. The proposal includes several tough reforms, including the creation of a single national banking charter, the elimination of the weak Office of Thrift Supervision, and new consumer protection measures. But the administration's plan for regulating derivatives, which include products like credit default swaps, which many believe contributed to the financial meltdown, has a loophole you could drive a truck through.

The new rules proposed by the White House call for all standardized derivatives to be traded through a regulated central counterparty (CCP), a kind of middleman. The Obama administration also wants to move "the standardized part of these markets onto regulated exchanges and regulated transparent electronic trade execution systems." But more complex "customized" derivatives would not face the same requirements. Instead of being required to clear their custom derivatives through a CCP, traders would simply have to report data about custom derivatives to a "regulated trade repository." The trade repository would be far from transparent, releasing only aggregrate data about custom derivatives to the public and only providing data about individual derivatives to regulators on a confidential basis.

In theory, it should be easy for traders to get around the CCP clearing requirement, since there's nothing to prevent lawyers from easily modifying "standardized" derivatives contracts to magically "customize" them. And the avoidable CCP requirement is itself less than some reform advocates wanted, as Josh Harkinson explained last week. Sen. Tom Harkin (D-Iowa) introduced legislation for all derivatives to be exchange traded. But the banks and other entities that own credit default swaps and other derivatives don't want those products traded on an exchange.* The Big Money's Martha White explains:

[A]n exchange would create what the experts term "price discovery." It would do for the derivatives market what e-commerce did for the retail landscape. If you wanted to buy a set of patio furniture in the pre-Google (GOOG) years, you would just go to the store and pay whatever the tag read. Now, with a few keywords and clicks, you can comparison shop among dozens of merchants.

What banks really want to avoid is mandatory exchange trading because they pocket the difference between the asking price and the offered price in an opaque market. This difference would still be present in exchange-traded products, but it would be much smaller because everyone would be able to see the going rate, so bid amounts would be much closer to sellers' asking prices.

In other words, the banks want to prevent derivatives transparency to make it easier for them to screw people. And the Obama administration seems to be willing to let that happen.

Last month, I warned that the administration was considering just this sort of regime for derivatives. The previous derivatives regulation regime, created in 1989 by "Foreclosure" Phil Gramm's wife, Wendy, when she was head of the Commodity Futures Trading Commission, made a similar distinction between custom, "individually negotiated" derivatives and standardized derivatives. The standardized derivatives had to be traded on exchanges; the individually negotiated derivatives did not. So of course traders simply claimed that all of their derivatives were individually negotiated, and, as derivatives expert Frank Partnoy explained in a New York Times column in May, "the exception swallowed the rule." In 2000, Phil Gramm finished what his wife had started, pushing through the Commodity Futures Modernization Act, which left derivatives essentially unregulated.

Now the Obama administration is making the same distinction that Wendy Gramm did in 1989. The administration at least acknowledges that it might have a problem, warning that "to make these measures effective, regulators will need to require...that customized OTC derivatives are not used solely as a means to avoid using a CCP." But if the White House is aware that customized derivatives might be used as a way to get around CCPs, why are they making the distinction in the first place? Some will claim that simply reporting confidential data to regulators is enough. Won't the regulators just take care of it? Well, the regulators missed the housing bubble. Partnoy's suggestion seems like it would work a lot better:

The current crisis is proof that although most people do not trade derivatives, everyone is subject to their risks. All derivatives, exchange-traded or private, must be in the sunlight. If institutions want to negotiate individual derivatives contracts, they should tell investors the full details of their exposure.

Why should that be so hard?

[Robert Weissman has a great summary of some of the other problems with Obama's proposals.]

*It's worth noting that some experts don't think derivatives like credit default swaps should even be legal in the first place. Credit default swaps allow you to buy or sell insurance on debt you do not own. George Soros says "it's like buying life insurance on someone else's life and owning a licence to kill." There's a reason you can't buy fire insurance on your neighbor's house—it gives you an incentive for arson. Maybe the same rules should apply in finance.

Page 1 of 1

Nick Baumann covers national politics for Mother Jones' DC Bureau. For more of his stories, click here. He can also be found on twitter.

36 Comments | Post Comment

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Derive THIS

Submitted by GarySeven on June 17, 2009 - 4:42pm.

tagged as:

solution

I am ALL done with the stock market. I'm still in trouble with the IRS about stock trades that I'm supposed to have made thousands of dollars from, haven't yet put together my records to show em that what I got back OUT of my stupid retirement investment account-thing was about...20 bucks. So yeah, they can keep that whole business they have going, there, and I'll be keeping my money...in a coffee can. It may not accrue interest, but I'll know where it is, and I won't have to pay service charges or taxes to access it. Somebody really needs to bleach down the deck there, an unenviable task, putting regulations in place on the 'free market economy', but in light of the fact that the last year has been an economic bloodbath for millions of people across this country and in other countries as a result of the whole little game finally shedding its' wheels, well, I don't know what to say except that if you're saving and investing and so forth, invest in a good personal safe, and save some of your money in it. That way, no hacker can steal it from you, no Bernie Madoff can sucker it out of you, and you don't have to pay taxes on it, so your only obstacle to savings at that point is YOU.

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I am still very glad I voted

Submitted by Trollstein on June 17, 2009 - 5:40pm.

I am still very glad I voted for Obama, but, that aside, he is far, far from the ass-kicker I had hoped for. He really needs to appreciate the fact that the public elected him because they wanted (and expected) a cross between Mr. Spock and Samuel L. Jackson. So far, what we got was a urban Andy Griffith who has allowed the attack dogs to continue to rome basically unteathered.
He is running out of time. This system is hanging on with spit and baloney-skins.
He thinks if he can reverse the clock to 1999, that all will be well again. Big fundamental mistake. The clock must be reversed to at least 1950. Basic decency and concern for our fellow humans must return or we will have no hope of recovery. Sad.

Hey, Thanks for the link.

Submitted by Derivative Dribble (not verified) on June 17, 2009 - 8:03pm.

Hey,

Thanks for the link. Shoot me an email if you get a min. There are a few things about this I'd like to chat about.

Best,

"Customized" Derivatives and screwing the customer

Submitted by David Manheim (not verified) on June 18, 2009 - 4:27am.

I'm going to point out a couple fairly obvious points - obvious to someone who has spent a couple years working with OTC and listed derivatives in an I-Bank, opaque to most outside of that milieu.

First, the people getting screwed, by and large, are other sophisticated users of derivatives. They want customizations, the banks charge a larger premium. No retail investors are getting messed over on the spreads for custom OTC contracts - they are actually not allowed to invest in them anyways. The banks do this because a hedge fund wants to asian out an equity call, or because they need to hedge a specific type of fixed income structure. More transparent markets don't help, because these are one-off transactions.

The other thing to pint out is that this is a marketplace. If consumers want listed products, they will buy them. Most hedge funds, for instance, want to hide what positions they are creating, and any public exchange prevents this. If their positions are public, they can be destroyed by the market because of their limited liquidity and time frame - see LTCM. Others will trade in public markets, which I-Banks generally like. Price discovery in the listed market allows them to price their exotics, which lets the traders hedge their risks, and the exotics traders care about very little more than they care about making sure they are properly hedged.

not usually a fan of the

Submitted by mike flynn (not verified) on June 18, 2009 - 4:53am.

not usually a fan of the DEMs. however, i was hoping they would go populist all over wall st. (BTW i am a registered broker) derivatives and over leveraging to buy them must be stopped. if obama and DEMs won't we are no longer participating in a democracy. we are victims and chattal of the corporatist gov't.

The neolib Obama keeps oozing out

Submitted by SocraticGadfly (not verified) on June 19, 2009 - 10:29am.

First, @Trollstein - I'm very glad I voted, too: GREEN, as I did in 2004. I saw Bill Clinton II, a darker shade of pale, to riff on Procol Harum, more than a year ago.

Both Krugman and Joe Nocera see serious, serious issues with Plan Obama. No new regulation of ratings agencies like Moody’s; no regulation of designer derivatives; banks “too big too fail” still allowed.

So, other than not tightening regulations on the three main causes of the financial sector meltdown, it’s a great plan.

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Yes, the big banks on Wall

Submitted by estetik ameliyatlar (not verified) on September 12, 2009 - 3:29am.

Yes, the big banks on Wall Street support the endless national discussion across the United States over health care reform because the longer such legislation is debated and delayed, the less chance any banking regulation will get through Congress and that's great as far as Wall Street bankers are concerned.

First the trades are

Submitted by Göğüs estetiği (not verified) on September 14, 2009 - 7:24am.

First the trades are executed directly between the parties, then they get moved to a CCP. So, under Geithner’s plan, trades cleared on a CCP would still be entered into between buy-side clients and OTC dealers. This means that the dealers are not losing business to exchanges, at least not under this part of Geithner’s plan. In fact, the market has already started moving dealer-to-dealer trades onto CCPs in anticipation of this kind of regulation.

We need to distinguish

Submitted by Plastik cerrahi (not verified) on September 15, 2009 - 6:33am.

We need to distinguish between the entities that are liable for the trades (the dealers and the CCP) and the entities that actually process the trade information and payments. In the case of ICE, trade information is processed by both TCC and DTCC. After that trade information gets processed, DTCC submits payment instructions to CLS Bank, which actually handles the payments haarverpflanzung, karın estetiği, schönheitschirurgie,
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There are major gaps and

Submitted by Estetik cerrahi (not verified) on September 16, 2009 - 6:49am.

There are major gaps and shortcomings in the Obama administration's financial regulatory proposals, formally released today, and the proposals alone leave the financial sector vulnerable to future crisis lazer epilasyon, karın germe ameliyatı. Still, it's nice to be able to say that the proposal does contain meaningful reforms estetik ameliyatlar, karın estetiği.

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