(Updates penultimate paragraph with agency votes on swaps dealers.)
The derivatives industry is squeezing Washington like a python. Desperate to control the tone and thrust of derivatives regulation, industry lobbyists have been swarming over the Commodity Futures Trading Commission and the Securities and Exchange Commission, each of which is writing derivatives rules as mandated by the Dodd-Frank reform law.
In case their lobbying falls short, the industry -- largely dealer banks and commodities firms -- has been pushing legislation that would pre-empt the rulemaking process and tie the agencies’ hands. So far, no fewer than 10 such derivatives bills have been introduced in the House; two have passed and several more have cleared committee.
Not satisfied with that, influential lawmakers have been not so subtly warning regulators to go easy on derivatives. This is incredibly intimidating: Congress controls the agencies’ budgets, and the increase in workload mandated by Dodd-Frank leaves them woefully short on funds.
And should a derivatives rule unpalatable to the dealers somehow survive this Beltway obstacle course, the agencies face an explicit threat of a lawsuit. This has had a chilling effect. As Bart Chilton, a CFTC commissioner, told me, regulators fear there is “litigation lurking around every corner and down every hallway.”
The subtext of this power play is, of course, the 2008 financial crash, in which derivatives played an important role. Look no further than American International Group Inc.’s notorious mortgage-insurance contracts, which triggered the run of financial bailouts. Or the synthetic collateralized debt obligations that multiplied the market’s exposure to subprime mortgages.
The intent of Dodd-Frank is to bring the derivatives business out of the shadows -- first to get a handle on systemic risk, second to create greater price transparency and narrower margins in a business dominated by a handful of banks, and third to protect the sort of customers who shouldn’t be playing with matches. (The Jefferson County, Alabama, adventure with derivatives and exotic debt, purchased from JPMorgan Chase & Co., last year ended in the largest municipal bankruptcy filing in U.S. history.)
The industry has often said it supports the aims of Dodd-Frank; it opposes only some details of the law and the rules being crafted to implement it. The particulars are indeed complicated, and no one understands them better than the banks. The dealer lobby -- led by the International Swaps and Derivatives Association, and joined by big customers and bank lobbyists -- maintains that derivatives are already priced competitively. The industry also says derivatives are safer than they were a few years ago because more contracts are “cleared” -- guaranteed by a centralized third party -- and because most users post collateral. They argue that proposed rules will gum up the system, increase trading costs and leave markets less liquid.
The banks are opposed by a vociferous counter-lobby -- groups such as Americans for Financial Reform -- but not surprisingly these have neither the financing nor the influence of the banks. Dealers have engineered new legislation to amend Dodd-Frank even before it leaves the delivery room. Pending bills would curb the proposed new exchange-like arenas for derivatives trading, grant regulatory exclusions on intra-company swaps (when one affiliate of Goldman deals with another), and shield from scrutiny the transactions of overseas affiliates of U.S. firms. Also, the banks have been battling to duck liability for the next Jefferson County.
Model of Deliberation
The proper place to hash out such differences is precisely at the agency level. Neither the SEC nor the CFTC has been arbitrary or closed to the industry view. In March, the CFTC met with roughly 100 outside parties, holding numerous sessions with banks, users and public-interest groups. Given that Dodd-Frank was enacted in July 2010 and the rulemaking is still in process, the agencies have been a model of deliberation.
It is hard to see why industry would attempt an end run around the rulemaking -- save that it wants to protect one of the most lucrative and highly concentrated sectors on Wall Street. The House bills are so specific they are almost comical. It is doubtful that members even understand what they are voting on.
This legislative pre-emption recalls a similar interference by Congress in 1999-2000, when Arthur Levitt, then chairman of the SEC, sought to enforce higher standards on corporate auditors. Congress threatened to strip the agency of its power to regulate audits; Levitt was forced to compromise. Less than a year later, America was hit by a wave of corporate accounting scandals, including that of Enron Corp.
The derivatives industry has its own history of regulatory pre-emption. Derivatives were a wunderkind innovation, a less cumbersome way to invest, speculate or hedge than traditional instruments such as stocks and bonds. Their very ease promoted use, like a pill that was easy to pop. You can use a derivative, of course, to reduce risk or to enhance it. The emblematic example is of the farmer selling wheat futures to lock in his price ahead of the harvest. (Futures are derivatives that trade on regulated exchanges.) Clearly, the farmer is hedging -- reducing risk. But traders might also be people with an opinion about wheat prices -- that is, speculators.
In the 1980s, the number of derivatives blossomed, especially the less regulated, off-exchange variety. So did speculation. One much-praised product, the adjustable-rate mortgage, was in fact a vehicle for turning stable home financing into an instrument of risk for homebuyers.
As derivatives markets grew, so did examples of spectacular failures. Merton Miller, the Nobel laureate economist, said the fiascoes were merely growing pains as users learned to “manage risks.” But the failures kept occurring, most dramatically with the 1998 meltdown of hedge fund Long-Term Capital Management. The then-CFTC chairman, Brooksley Born, proposed that Washington consider regulation of off-exchange derivatives. She was shouted down by the banking lobby, ably represented by Robert Rubin, Larry Summers and, especially, Alan Greenspan, who opined that derivatives agreed to by self-interested profit seekers didn’t need regulation. The market would self-regulate.
The Greenspan philosophy was codified in the Commodity Futures Modernization Act of 2000, which cast the industry back 100 years. It forbade most regulation of swaps and, indeed, exempted swaps from century-old bucket-shop laws enacted, in a more sober spirit, to prevent storefront gambling. Since that act, the notional value of derivatives has soared from $95 trillion to more than $700 trillion.
The laissez-faire assumption is that more liquidity -- that is, more trading -- is always better. The view here is different. Derivatives that transfer risk from, say, banks to anonymous speculators also transfer credit decisions to disparate, generally less-informed players. This also occurs with bonds, but bonds are securities and regulated as such. Credit-default swaps (contracts in which speculators wager on defaults) have turned Wall Street into a giant betting parlor.
According to research by Thomas Philippon, a professor of finance at New York University’s Stern School of Business, the array of such new vehicles have not rendered financial markets more efficient; they merely permitted the financial industry to extract a higher share of the national income for “increases in trading activities whose social value is difficult to assess.”
Another study, by law professor Eric Posner and economics professor Glen Weyl, both at the University of Chicago, found that credit-default swaps didn’t contribute to social welfare because they didn’t improve the markets’ ability to forecast defaults. Such swaps were used mainly by speculators (few of the people trading swaps on Greek defaults actually owned Greek bonds). At least proponents of new futures contracts are required to submit a brief for their “economic purpose”; the authors propose a similar test for off-exchange derivatives.
Banks note that their customers are clamoring for derivatives. But health-care consumers also clamor for drugs and treatments, not all of which are useful. “The great question,” says Wallace Turbeville, a former Goldman Sachs Group Inc. banker and now a senior fellow at Demos, a liberal think tank, “is ‘Why do companies hedge the way they do?”’
It is one writer’s opinion, but a generation of corporate treasurers has been overschooled in the notion of “managing risk.” They adopted as gospel a mandate of hedging the near-term movement of every conceivable financial asset. This serves the banks that deal in derivatives, and it serves corporate managers who have an interest in avoiding short-term embarrassments. It doesn’t serve long-term shareholders. Hedging is as overused as pills, and too easily crosses the line into gambling.
A leitmotif of Dodd-Frank is defining when the Wall Street banks act as agents or advisers for their customers, and when they are principals trading on their own accounts. Since they take the other side of customers’ derivatives trades, banks are generally classified as principals, not responsible for customers’ bad decisions.
However, Dodd-Frank directed the regulators to protect certain less-sophisticated users, who also represent a public interest, such as municipalities and pension funds. Banks protested, and pension funds, with their misplaced enthusiasm for financial exotica, said they didn’t need, or want, “protection.”
The CFTC devised a tough, and sensible, proposal. When a pension fund or municipality bought a generic derivative, its dealer wouldn’t be liable. But if the bank tailored a customized product specifically for that customer, then, according to the proposed rule, the bank had a duty to sell a suitable instrument, and to advise the client in its own best interest. This hardly sounds burdensome. But the industry, fearing potential liability, unleashed a torrent of protest. The CFTC caved and revised the rule so that clients will be permitted to waive their right to good advice.
Probably, the CFTC was intimidated because Congress has granted it only $205 million (a flyspeck compared with the resources of banks). That is one-third less than the agency says it needs. Thus far, though, it has stood its ground on another big issue, the rules governing “swap execution facilities” -- the electronic marketplaces for swaps. The aim is to corral buyers and sellers in a more transparent setting. Dodd-Frank mandates “a trading system or platform in which multiple participants have the ability to execute swaps by accepting bids or offers made by multiple participants…” The industry never liked Dodd-Frank, and the House, of course, has changed leadership.
One bill would amend Dodd-Frank by prohibiting the agencies from requiring that multiple parties see bids and offers, or that customers display their bids to multiple dealers. The industry and, it must be said, many big users argue that disseminating customer intentions could hurt their bargaining position in the way a poker player loses his edge if other players can see his cards. Costs will rise, liquidity will fall.
According to the ISDA, the requirement that quotes be posted on a centralized screen “may limit competition” by deterring users who are wary of such exposure. Maybe, but in virtually every other market, openness results in better prices. And when lawmakers forbid regulators from requiring that trading venues “have a minimum number of participants receive a bid or offer,” it sounds like a funny way to spur competition. Turbeville, the former Goldman banker, says the industry-backed bill would turn the new trading venues into “a glorified telephone.”
Very likely, if industry isn’t satisfied, it will go to court. Last year, in a long overdue move, the SEC approved a rule making it easier for shareholders to nominate directors, thus infusing a smidgeon of democracy into boardrooms. The Business Roundtable, which represents chief executives, sued, claiming that the SEC had not properly studied the economic impact. The conservative Court of Appeals for the D.C. Circuit found against the SEC, even though it had supplied 60 pages of analysis on the potential economic effect. The Harvard Law Review observed that the court’s “exacting review could impose a judicial blockade on complex financial rulemaking.”
The U.S. Chamber of Commerce has made no secret of its desire to bring similar suits. The CFTC is already in court over one new rule to control speculation in futures trading; the plaintiffs, including the ISDA, charge the regulator with insufficient economic study. Now the regulators are editing themselves: On April 18, the CFTC and the SEC voted to oversee only those companies that conduct at least $8 billion in swaps a year, a much higher threshold than proposed and one that will let many a bank, hedge fund and energy company slip through their grasp.
Derivatives regulation has too long gone undone. The agencies should be permitted to do their job. Congress should lay off the intimidation tactics, which in the past have embarrassed Congress itself. Restricting the agencies (by blocking regulation of overseas or affiliate deals, for instance) poses the risk that regulators will see only one side of the street, or attempt to deal piecemeal with what is clearly a global industry. Not every rule is perfect and industry is free to make its case to the agencies. End runs in Congress, even more so in the courts, threaten to kill regulation by a thousand cuts and a thousand delays.
(Roger Lowenstein is the author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” He is an outside director with the Sequoia Fund. The opinions expressed are his own.)
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