Click on the section of the Commodity Futures Trading Commission website about the 2010 Dodd-Frank financial-reform law and the first thing that jumps out is a quotation, in bold, from CFTC Chairman Gary Gensler about how Dodd-Frank would transform the derivatives market -- for the better.
“The Wall Street reform bill will -- for the first time -- bring comprehensive regulation to the swaps marketplace,” wrote Gensler. “Swap dealers will be subject to robust oversight. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. The commission looks forward to implementing the Dodd-Frank bill to lower risk, promote transparency and protect the American public.”
Ah, if only things had turned out that way.
Instead, almost three years after Dodd-Frank became law -- during which time there was at least a glimmer of hope that by requiring opaque and hard-to-value swaps and derivatives to be traded on an exchange, market pricing would prevail -- the CFTC voted May 16 for a watered-down compromise. It allows swaps and derivatives dealers -- essentially the big Wall Street banks -- to continue to set the prices for these financial instruments using their black boxes.
It’s yet another example of how Wall Street uses its “death by a thousand cuts” strategy to get what it wants and to essentially neuter hoped-for regulation that had the potential to be truly useful. Frankly, the CFTC’s 4-to-1 vote is both distressing and disappointing.
In the end, the commission agreed to make a minor change in the way swaps and derivatives are traded. In the good old days, before Dodd-Frank, if Morgan Stanley and Goldman Sachs Group Inc. wanted to enter into a swap, they negotiated the price among themselves. Assuming they could agree, they did the deal. Aside from the bankers at those two Wall Street behemoths, no one else would know the price of the deal. This lack of price transparency of hard-to-value financial instruments became a big problem in the year or so leading up to the financial crisis of September 2008.
In one example, by selling credit-default swaps, American International Group Inc. agreed to insure the price of billions of dollars of Goldman Sachs’s mortgage-backed securities and collateralized-debt obligations. But as the value of these securities fell in the marketplace, Goldman had the ability to demand more and more collateral from AIG as a way to insure that AIG would make good on its agreements. If Goldman believed an AIG-insured CDO it owned was worth 60 cents on the dollar, it could demand that AIG post the remaining 40 cents as collateral. Not surprisingly, AIG and Goldman eventually got into collateral disputes, with Goldman demanding billions of dollars of additional collateral from the insurer, and AIG disagreeing with Goldman’s valuations. In the end, AIG made some payments to Goldman -- in the billions of dollars -- but Goldman’s collateral demands unquestionably exacerbated AIG’s collapse and eventual federal takeover.
Under the CFTC’s new rules, Morgan Stanley and Goldman Sachs can no longer unilaterally agree among themselves on the pricing of a swap deal -- there is now a requirement that one other firm also submit a price. Whichever firm offers the seller of the swap the better price would prevail. And, for the first time ever, after the price of the deal is agreed on, it will be displayed on an electronic terminal, such as a Bloomberg, and an “audit trail” will be created that the CFTC can monitor. (As a minor concession to greater openness, starting 15 months from now, under the new CFTC rules, a third bidder -- as opposed to just two bidders -- would be required to submit a price before a trade can occur.)
That may look good on paper, but looks are deceiving. The problem is that the CFTC commissioners seeking genuine reform of the swaps and derivatives markets -- including Gensler and Bart Chilton, who has been the toughest-minded member of the commission since joining in 2007 -- had wanted to require that as many as five firms submit prices. That makes sense: As in any market, the more transparency and more bidders, the more price clarity there would be. With just one additional bid required, the big boys should have no trouble gaming the system, as they have for years. And price transparency itself means little if the bidding isn’t fully open.
Unfortunately, Gensler and Chilton couldn’t muster the one additional vote needed among the five members. Instead of meaningful change in the way swaps and derivatives are traded and prices set, we are left with a disappointing compromise and the likelihood of cartel pricing by the big banks for years to come. And Wall Street has won for itself yet another victory in its seemingly never-ending campaign to whittle away Dodd-Frank to irrelevance while no one else is looking.
Chilton ended up voting for the measure -- he knew he was voting for something he didn’t like, but decided to try “holding my nose” and voting yes so that there would be at least some tiny bit of price transparency. “I’ve never been a more reluctant and reticent regulator than today on these rules,” Chilton said during the meeting. “I just wish we had reached a different compromise.”
In an interview, he said the compromise was the “worst thing” he had voted for as a CFTC commissioner and that when the drafters of Dodd-Frank asked for “multiple” bids on swaps and derivatives, “they meant more than two, that’s for sure.” He said the CFTC’s vote met the “bare minimum of acceptability under the law and was far less than those who voted for Dodd-Frank had hoped for.”
“Did Wall Street win on a few individual provisions on this rule?” Chilton said. “They sure as hell did.”
Next up for Wall Street’s grinder: Whatever remains of the so-called Volcker rule, which would restrict proprietary trading at banks holding federally insured deposits. Even though the rule is supposed to be implemented by next year, Chilton said it remains the province of the Federal Reserve and he has heard nothing about it for months. “It’s MIA,” he said. “I don’t think anyone cares about it anymore -- other than me.”
(William D. Cohan, the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. He was formerly an investment banker at Lazard Freres, Merrill Lynch and JPMorgan Chase, against which he lost an arbitration case over his dismissal. The opinions expressed are his own.)