How To Kill OTC Derivatives Reform in Two Sentences

The post below, which looks like it could be extremely important, is by Mike Konczal, author of the popular (for those in the know) Rortybomb blog, a previous guest blogger on this site, and now a fellow at the Roosevelt Institute — James

Have lobbyists snuck another major loophole into the OTC Derivatives bill? This week the final touches are being put on Barney Frank’s financial regulation bill – H.R. 4173 – “Wall Street Reform and Consumer Protection Act of 2009.” One of the centerpieces of this reform is Title III: Over-the-Counter Derivatives Markets Act. And one of the goals of this reform would be to get as many derivatives as possible to trade on exchanges.

An initial hurdle for Barney Frank was what to do with an “end-user exemption.” This would exempt certain types of derivative buyers who use derivatives, say corporations hedging interest rate risk without speculating, from the extra scrutiny and regulation that comes with the exchange/clearing system. One of the narratives of financial reform so far has been that this initial end-user exemption was too large a loophole at first, and instead of just handling 10-20% of the market, it would let a large majority of the market sneak through, but ultimately Barney Frank was convinced by consumer groups and people pushing for stronger financial regulation and fixed this issue. See Noah Scheiber here in “Could Wall Street Actually Lose in Congress?” for this story, and it shows up as well in a recent profile of Barney Frank in Newsweek.

I thought it was a little too early to declare victory, and sure enough instead of attacking and weakening how people will have to use the exchanges, lobbyists have re-focused their attack on the idea of the exchange itself. For a while, reformers have been worried about an “alternative swap execution facility.” This would be a way of essentially allowing the current way things are done to be allowed to count as an exchange. Fighting off this loophole was a battle from a month ago, and it had appeared to be won. Now many are worried that this language appears to have snuck back into the final bill now.

Colin Peterson (D-MN), Chairman of the House Committee on Agriculture, along with Barney Frank, has added an amendment to the OTC Bill (opens large pdf). There are two relevant sentences for reformers from the long document. The first is on page 32:

(49) SWAP EXECUTION FACILITY.—The term ‘swap execution facility’ means a person or entity that facilitates the execution or trading of swaps between two persons through any means of interstate commerce, but which is not a designated contract market, including any electronic trade execution or voice brokerage facility.

This replaces other language in the original bill (opens even larger pdf), on page 546:

(A) No person may operate a swap execution facility unless the facility is registered under this section.

(B) The term ‘swap execution facility’ means an entity that facilitates the execution of swaps between two persons through any means of interstate commerce but which is not a designated contract market.

So notice any differences? First the definition of a swap execution facility has been expanded to include “a person” (different from the “or entity”). It’s also expanded to an “or trading” definition, and includes voice brokerage firms. So now we are moving from the definition of something that is a platform for swaps to be traded on to instead something that simply helps swaps get traded. This could, quite simply, be a telephone over which two people trade a derivative (with one person declaring himself to be the exchange?). Instead of changing the way business is done for reform it looks like it redefines reform as the way things are currently done, and just calls it a victory.

Now on page 89 of the amendment:

(2) RULES FOR TRADING THROUGH THE FACILITY.—Not later than 1 year after the date of the enactment of the Derivative Markets transparency and Accountability Act of 2009, the Commission shall adopt rules to allow a swap to be traded through the facilities of a designated contract market or a swap execution facility. Such rules shall permit an intermediary, acting as principal or agent, to enter into or execute a swap, notwithstanding section 2(k), if the swap is executed, reported, recorded, or confirmed in accordance with the rules of the designated contract market or swap execution facility.

The second sentence here allows an intermediary to execute a swap, ignoring the section 2(k) which is the meat of the reform, as long as the swap is recorded somewhere. Now we already have, from above, that a swap execution facility can be something other than the exchange. This is a rule that guts the regulation right out the door, and for no apparent benefit to reform. Many of these alternative swap facilities will be owned by the banks, so it won’t necessarily force the price transparency that has been promised. To trust regulators to simply do the right thing is naive at best when the ability to follow fixed rules is available.

From what I’m hearing, it is possible Frank doesn’t even know that this language, once in the bill as an amendment but removed, has snuck back into his reform legislation. Things are moving very quickly on the hill right now, and this is scheduled to be wrapped up by tomorrow. However this new language runs counter to the reforms Frank has promised to deliver to the American people. Either this language needs to be clarified before the bill is complete, or removed entirely.

48 thoughts on “How To Kill OTC Derivatives Reform in Two Sentences

  1. Sorry, anyone affiliated with a think-tank is a flack. Until we can vet people with computerized lie detectors, not worth listening to, and usually dangerous/counterproductive to do so.

    Come to think of it, journalists and high profile bloggers are flacks too. And so are commenters in a way.

    Welp, nothing left to do but chop wood.

  2. You cannot reform derivatives. You might as well reform bubonic plague. If you tax them and account for them currently and force full disclosure, they will disappear since their only raison d’etre is reg arbitrage and tax evasion and accounting fraud and manufacture of phony profits.

    Barney Frank’s bill is lipstick on the pig. As for Barney civilized decency prohibits fair characterization of him.

    Hyperinflation or debt deflation and depression? No one knows for certain which these bo obs are orchestrating. Time will tell.

  3. All sorts of Holland going on with this Roosevelt Institute. And Tobacco?! And booze?! And Hudson Valley and Rockefeller…

    Plus they’ve got what looks like a huge new initiative going on to infiltrate college campuses all over the country.


    Co-Chair: Richard E. French, Jr. Mr. Hudson Valley and local media magnate. (Good friend of David Rockefeller)

    Vice Chair: George L. Knox. Um, *this* George L. Knox from Phillip Morris?
    “Vice Chair” Get it?

    Vice Chair: Alison Overseth: Dutch heritage.

    Secretary: Nicholas Ludington; likes to award prizes to authors of books that describe how america (and england?) achieved total communications dominance during and after WWI.

    William J. vanden Heuvel
    Founder & Chair Emeritus: Masterspy and top monkey on the tree of influence, ambassador (Ferrero Rocher joke)

    Andrew Rich
    President & CEO: Professor of Poli-sci, expert on think-tanks; all Yaled up, “progressive,” and a Soros chum: “Rich also served as a consultant to the Open Society Institute from 2006-2008 and has worked extensively with foundations and donors interested in investing in a politically progressive infrastructure. He received his Ph.D. in political science from Yale University.”

    Plenty of other interesting directors:

    And governors! No shortage of governors:

    And finally donors. You can always tell a lot about a think-tank from the source of their funds. Highlights:

    American Postal Workers Union, Anonymous, Conrad Black (oh yes), George Chao-Chi Chu (Da Tung Commercial Trading Company – had monopoly on import of Taiwanese booze and a good chunk of the Chinese booze. Isn’t that the kind of business mobsters like to be involved with?) So we’ve got big tobacco in the house, alcohol… okay, continuing on… Coca Cola, Afl-Cio, The Lehmans, Henry Luce Foundation, Women’s League of China, Denise Rich, Starr Foundation, Taipei Econ and Cultural Office, lots of Heuvels and Roosevelts, and of course a Rockefeller, who always seems to be lurking when China’s around.

    Konczal, you’re a bright young fellow. Why are you associated with these people?

  4. Why is Barney Frank held up as some form of warrior for the little guy? He is extremely good at photo ops or berating CEOs on camera, but everytime he puts forward a piece of legislation to “reform” wall street or another intitution, once the details come out the policies are full of holes and exemptions. then if he is questioned he gets all uptight. Something is wrong with this government, even the gay democrat from Mass is in the back pocket of wall street. Either he is incompotent, and cannot produce a bill that effectively regulates financial institutions, or he is lying and attempting to pass status quo legislation as some form of change. Which is worse?

  5. The financial “industry” will always be able to finesse its way out of complex regulations. The best strategy against that is extreme simplification. No exceptions, no nothing.

  6. This proves again that regulation cannot work. The level of criminality is too entrenched, as we see here with Frank and the utterly vile Colin Peterson.

    (“Ultimately Barney Frank was convinced by consumer groups and people pushing for stronger financial regulation and fixed this issue”. Shouldn’t that read, was dragged kicking and screaming into a few things, and had to have the Audit the Fed amendment passed against his opposition and his attempt to gut it and cripple reform with the Watt trojan horse amendment?)

    The obvious answer, which is clear and ardently called for by anyone other than a criminal, is to ban OTC derivatives and all commodity speculation.

    These have no place among civilized people. They reek of the swamps where pirates hide out. How did we let the stench overcome the entire country?

    When gangsters are this entrenched in the very legislatures, there’s no way the people will ever receive anything from the top down other than further assaults and robberies.

    All we can do is reorganize ourselves from the bottom up.

  7. This is in my opinion the best post this site has ever done, and no doubt somewhere in the top 5 posts in the history of this site. If Barney Frank or any other U.S. Congressman passes this language on page 89, it shows he has no concern for the future of America.

    Any bill a Congressman votes yes on he should have a clear understanding of the ramifications of that bill. If Barney Frank passes this bill with the language as stated above on page 89 he is signing the Death Warrant on the future of America, and is guilty of nothing short of treason.

  8. Thank you Mike Konczal and James Kwak, for caring about America more than our Congressmen do.

  9. What is the best way to focus insightful information and opinion like this into the halls of Congress? It seems voting people out doesn’t work. This is only the tip of the iceberg. D2 coming.

  10. I expect this piece has already been read by Barney Frank. There is a quite a bit of detail about financial elite fright being exposed here. If these changes in the language of the bill are presumed to have made it into law, in short order a furor would have erupted and probably precipitated a Technical Amendments bill and subsequent act. That would be the very last thing the financial elites would want to see happen because every technical amendment effort presents an open path to refining specific changes.

    I would think the furor over this little change would be very pronounced. As it is this exposure puts the spotlight on needed change. Rep Frank is probably very angry.

  11. Precisely. If it is too complicated to understand or in too small print to read without the aid of an electron microscope, it should be disallowed.

  12. I have thought all along that this depression is but a symptom of a political disease.
    Both parties are part of the problem, and neither of them sure look like they are doing anything to fix what is broke.

    I apologize for the silly pun in a serious post, BTW.

  13. Jerry I don’t think this qualifies as “financial elite fright” other than the usual rantings of Uncle Billy who seems to make extra effort to make commenters on this site appear one step away from the psyche ward.

    There has been similar type wording in other bills which due to the slumbering main stream media has gone unnoticed. See the following 2 links.

    You can see clearly the words SWAP used in those special exclusions put in the Gramm-Leach-Bliley Act of 1999 (Sections 206B and 206C of the GLB Act). Yet very very few people took notice. Now even though those swap exclusions from regulation were especially put in the GLB bill by Phil Gramm and his bank lobbyist friends, as you can see in the following video, Phil Gramm (now with a high salary job at UBS Investment bank) would have you believe he’s just an innocent little boy in this whole mess and that we should be thankful credit default swaps add so much “liquidity” to the system.

    The sad thing is, as Americans are busy reading how many porn stars some golfer slept with, oftentimes they only get upset AFTER THE FACT such draft legislation has turned into LAW.

    IN FACT, we should be getting this information from the Wall Street Journal which has many more resources and manpower than Mike Konczal and James Kwak have. But WSJ has joined Fox News as a dissembler rather than performing the duties of a functional member of the press in a democracy.

  14. I don’t like taking it up the tale no matter what Congress may prefer. This is an outrage. This, along with news that “cov light” loans are back together with loans to finance payouts to leveraged buyout firms (I know I’m old fashioned), is a warning to us all. Cash in and put it under the mattress!

  15. There is ONE place for OTC derivatives – Las Vegas. Period.

    For more than a decade, I’ve referred to Wall St. as Las Vegas West.

    The days of issuing stock to raise capital and then share the profits (via DIVIDENDS) is basically over.

    I never was fond of the whole public company model. I think the current state of affairs illustrates why…in the extreme. The publically owned model undermines the creation of, and ongoing operation, of productive companies that aim to produce the best products at the best value, and treat their employees with respect. The push has become to grow (at least appear to grow) at all costs, to manipulate share prices – to benefit “the house” (GS, JPM, Merrill, the US Gov’t) and other traders. A company with a steady 5% or 10% profit per annum is viewed as a dud.
    Something is wrong with this model – big time.

    Aside: I also wonder what would happen if we turned off the technology (computers, PDAs, cell phones) and returned to paper to trade, settle, and account. I bet that would change things in a hurry.

  16. Ted, by fright I mean the straight forward idea of financial elites that they must head off derivative legislation or else. They win and stop the attempt to control them or continue to give up control. It is their line in the sand. If elites lose this issue they are wide open for the likes of bonus taxes as Darling is going to do in the UK .

    It has been common practice in the recent past for entire acts to be drafted for Members of Congress to introduce by special interests.

    My own view is that Wall Street big shots had absolutely no idea what a political furor would be thrown up by their failure in allowing the media frenzy over bailouts and bonuses to take on the parameters it has. They were clueless about populist rage. These people truly are clueless about such things. The same is true about corporate elites in the US. They are very much disconnected from the politics of the street. They literally believe their own delusions. Their focus is that of the specialist that lacks the education of a generalist.

    Special interest insertions into the law or even entire laws are a long standing aspect of business as usual in Washington and state capitals. What matters to them is that the attempt be interdicted. Nothing new here. But these elites are now very scared. Both financial and political elites and circumstances now separate them more than uniting them.

  17. Financial regulation must adopt the FDA paradigm, that is, it MUST be tested, questioned, analyze and dissected BEFORE even going to market.

    We do it for drugs and medical devices which can affect individual lives. I’m still waiting for a sensible rationale that would exempt financial products which affect millions of lives.

    In a word, what is not specifically authorized cannot fly. It’s that simple.

  18. I agree with Dr. Frankie but that day is not coming anytime soon. If that happens, most people on Wall Street will have nothing left to do.

  19. Transparency in derivatives by having them forced onto “public exchanges” is such a farce. From my perspective, it would not surprise me at all that Barney conspired or at least assisted in seeing that this language was inserted. He is bought by Wall Street just like his compatriots on the Hill. The reason why derivatives can’t be open, is that then we can tell just who is making the wildest and wooliest bets, when, and for how much. AND, who is holding the bag (everyone on my side of the world, i.e. the taxpayers).

    This reform is a real myth. However, if this gives some few honest, unbought people to be elected and start cleanup, maybe after the next round of elections, we’ll get around to re-reforming the reformation. The unfortunate thing is that by then it may be a little too late to matter. Another year of insanity betweent the FED and Wall Street is probably all they need to completely ruin our economy for decades, if not perminently.

  20. Unfortunately populists are clueless as well, they are angry and so want something they don’t understand banned. I think it would be better for derivative trades to be published, but the problem isn’t with dark pool trades of derivatives, it’s with financial companies and banks taking on excessive risk and over-leveraging. Derivatives in themselves are good, they are tools, very helpful if used correctly, but the outcome depends upon the user. The goal should be to limit the amount of leverage (ie. risk) financial companies can employ, not to ban derivatives or derivative trading which will go on regardless because they are useful tools. Transparency of the derivatives market is a good thing that I support by the way.

    In theory, regulators are supposed to watch over firms and stop them from taking on too much risk. Regulations require regulators to enforce them. Unfortunately, regulators have shown themselves to be largely incompetent just like most government bureaucrats. So we need a second line of attack.

    Financial company executives should not receive bonus compensation for taking on risk. People probably understand that taking risk produces gains, it’s how insurance companies make money, and also how Las Vegas Casinos generate profits, from taking bets. However the blackjack dealer doesn’t get a bonus should the player bust and lose his bet. He didn’t do anything other than accept the bet on behalf of the casino. Same for these executives. The only people who should reap the rewards from risktaking are those who put their capital at risk, the shareholders. For some reason, this very important and logical concept hasn’t gotten the traction it deserves. Without incentives to take more risks with shareholder money, executives wouldn’t overleverage and wouldn’t bet the farm away. We have to attack the root of the problem which are the incentives and bonus structure, all unfair since it takes no skill to accept risk, just like it takes no skill for the roulette dealer to collect all the chips on the table once 00 hits. The analogy is imperfect because derivatives are actually useful and not just a game for fun, but the point is the same. Only those with capital at stake should reap the rewards from accepting risk.

  21. Completely disagree with most of this, especially:

    “Derivatives in themselves are good, they are tools, very helpful if used correctly, but the outcome depends upon the user.”

    cf. Gun analogy. No guns, or at least no guns in the hands of sociopaths and cretins, very few gunshot wounds. Just a simple fact. Make a list of the advantages of derivatives; explain why they are good. I suspect it won’t be very long, and it certainly won’t be convincing. Companies can hedge? Distribute risk, blah, blah, blah? How bout companies just do things and get paid for doing them, thereby generating profits, which they can reinvest in themselves. They want to grow? They can borrow from the bank or from friends. They want to grow fast? Tough shit… we’ve had enough fast growth. Better yet, build a planned economy without the corruption. We can feed, clothe, shelter, provide medical care for, and otherwise treat like a human being, every human being on this planet. You don’t like this because you want to live in a luxury condo and drive a nicer car and feel superior? You’re common and obsolete. Keep up with the Jones’s and/or surpass them by writing a better symphony, or expanding our knowledge of physics, or by making a quality chair.

    (Sorry, not directed at you personally — Just at people who understand the mechanics of gambling and defend derivatives)

    Did you go to HS in NoHo by chance?

  22. I agree. Derivatives without leverage are generally harmless. I doubt they have been used since 1983, when IBM and the World Bank did that currency swap.

  23. Please consider sending this article to your Congressman and anyone else you can think of to put pressure on Congress to end this bate and switch.

  24. Outside the window of my office I see a river flowing on its way to the ocean. People have drowned in that river! Therefore, government should dam the river so no one else drowns.

    No wait… that would be silly.

    I have private financial contracts on my personal books. Other private people have gone bankrupt with these same contracts on their personal books. Therefore, government should ban transactions in private contracts so no one else goes bankrupt.

    No wait… that would be silly.

  25. So, who drafts the bill anyway?

    Is it acceptable that the financial “industry” has a hand in that? Would it acceptable for students to help their professors drafting the questions for the exams?

  26. It’s interesting how the casino analogy comes up so frequently when it comes to the financial system. Perhaps the Dubai World / MGM Mirage joint venture in Las Vegas is an epitome of the failure of an “advanced” financial system.

    The tagline for this “mirage” is: The Capital of the New World.

  27. Mike, isn’t it possible that many of these transactions really *cannot* be exchange traded or cleared? It’s my understanding that US accounting rules require companies to match very closely the terms of the risk they’re exposed to with the instrument they’re using to hedge that exposure. The consequence of not doing so, as I understand it, is that the instrument must be marked to market on the company’s income statement, which no CFO ever wants to happen. So companies with very specific risks – and surely that includes most public companies – won’t be able to hedge with generic, exchange-traded derivatives products. That’s where banks, swaps dealers and these customized OTC instruments enter the scene. How are companies supposed to precisely hedge risks without them?

  28. The casino analogy is spot on, since the GLB law specifically excludes swaps from regulation under gambling laws.

  29. Accounting rules should be changed, if exchanged traded swaps are somehow forbiden from use. That’s a simple solution which doesn’t affect the structure of why they’re used in the first place.

    Anyway, Frank’s my congressmen and I’ve forwarded comment regarding the exchange as ‘person’ vs keeping it an ‘entity’ as worded in the un-amended text we prey survives.

    Hanging around and bitching about it doens’t work. This is bi-partisan stuff if voters and representitives would just comit themselves to learning where things need to be fixed. I also put in a good plug for Paul Volcker ;)


  30. What is not an acceptable social result to group A is a politically desired result for Group B. One of the groups will prevail politically. Federal Republics are by nature a cesspool of factions. Politics is the art of organizing the cesspools of factions into a commonwealth. US politics was once a master of the genre. No more. Personally, the nadir of commonwealth building was the French Third Republic. Again personally, US paranoid politics, the politics of personal good, has reduced the US to the level of the Third Republic. Probably worse in my view.

    Interest groups create “model acts” that go to their politically allied members of Congress for introduction as a bill they sponsor.

    Just who drafted the various model acts that became the introduced health bill in the House and Senate? Those rounded 2000 pages were hardly put together entirely by Congressional staff law writers. Very expensive law firms of interested parties did. Interested political groups did that to present their position. The congressional staff then did their usual cut and paste jobs to arrive at what was to be introduced as a bill. Each sponsor of the bill put their two cents in the draft as supplied to them by interested parties and worked over by staff.

  31. Clear explanation, great summary:

    “Financial company executives should not receive bonus compensation for taking on risk. … The only people who should reap the rewards from risktaking are those who put their capital at risk, the shareholders.”

  32. Well said Russ. The continous filmstrip of kabuki theater known as “the legislative process” and “congressional oversight” hearings are just another form of reality television.

    These “representatives” are all crooks. Paid lakeys that do the bidding of the ultra wealthy power groups who think that the common folk are vermin to be exterminated.

    It needs to be bottom up and it needs to be bloody. All revolutions that promote change are. There is no “compromise” with these people. It is an all or nothing game and we are pitted against people for whom unlimited wealth and power is an addiction they can never abandon. And they will do anything to keep it.

  33. Do you think that corrupt bone smuggler is actually going to read your letter?

    The accounting rules have been changed. They changed them this year to make the banks appear to be solvent.

    The accounting industry has caved just like the rest of these suck-up bastards that would do anything for a crumb.

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