According to the Washington Post, the Senate Agriculture Committee is beginning to work on legislation regulating the vast marketplace in over-the-counter derivatives, which played a large role in the economic crisis, particularly in bringing AIG to the brink of collapse. Committee Chairman Blanche Lincoln (D-AR) said that she expects whatever the committee passes to be incorporated into Senate Banking Committee Chairman Chris Dodd’s (D-CT) larger financial regulatory reform effort.
Lincoln’s step up to the plate has already boosted the spirits of the financial services industry, as “they expect that legislation headed up by Lincoln could be more favorable to the financial industry than the language currently in Dodd’s bill.” And there might be reason for their optimism (and concern for those who want a tightly regulated derivatives market), as last month, Lincoln gave a speech on derivatives reform at the U.S. Chamber of Commerce, in which she said that “I don’t believe in over-reaching or regulation for regulation’s sake. We must be surgical in how we regulate.”
As the Roosevelt Institute’s Mike Konczal explained, the key to judging derivatives regulation is to determine how much trading is required to go onto public exchanges and how much will be mandated to go through clearinghouses. An exchange adds light to the marketplace by making trading information public, instead of the current setup in which derivatives deals can be made between two parties without any reporting. This should both drive down prices and give investigators a much clearer path to follow if shenanigans occur. A clearinghouse, meanwhile, acts as an intermediary between two parties in a derivatives trade, ensuring that each side has adequate capital on hand to make the deal and that each side lives up to its obligations.
During her speech at the Chamber, Lincoln said that “all swaps — both standardized and customized — should be reported,” while “clearing will be mandatory for ‘some standardized and highly liquid‘ swaps.” So the effectiveness of her legislation will largely revolve around what does and does not fall into the “some standardized” category.
As Commodity Futures Trading Commission Chairman Gary Gensler has said, the more trading that occurs in clearinghouses and on exchanges, the better. Gensler likened these to traffic lights that, while necessarily slowing down traffic, are critical to a safe system:
Do yellow and red lights slow down traffic? Do street lamps bring sunshine on otherwise dark and dangerous roads? Absolutely. Could we run a high volume transport network safely without them? Absolutely not. Traffic lights may add costs for all network users, but can anyone imagine a traffic system without safety regulation? Of course not.
To get a sense of how systemically risky the derivatives market can be, consider this statistic: “Since the 1980s, the notional value of the market has ballooned from less than $1 trillion to approximately $300 trillion in the United States – that’s $20 in derivatives for every dollar of goods and services produced in the American economy.” And more than 97 percent of this total is held by five mega-banks. This is a wild amount of money — and risk — so Lincoln’s bill needs to shed sufficient light on it if her legislation is making its way into Dodd’s bill.