One of the more contentious parts of the financial regulatory reform debate currently occurring on the Senate floor is over derivatives regulation, after Sen. Blanche Lincoln (D-AR) surprised many people by offering legislation that not only brings derivatives out of the dark, but would force commercial banks to place their derivatives trading operations under a separate roof that is independently capitalized.
Currently, a lot of derivatives trading occurs “over-the counter,” meaning it’s between two parties, without public information. Lincoln’s bill would place all standardized derivatives trades onto public exchanges (like the stock exchange), so that both investors and regulators can see what is going on in the market. It would also employ clearinghouses to act as the middlemen between trades, ensuring that both parties have sufficient collateral on hand should the deal go bust.
This approach would help to avoid another AIG-type situation, in which a party is making derivatives trades with nothing to back them up. Republicans, however, are not happy with Lincoln’s legislation. Sen. Saxby Chambliss (R-GA), along with Sens. Mitch McConnell (R-KY) and Richard Shelby (R-AL), have crafted an amendment that not only gets rid of the exchange trading mandate entirely, but gives regulators vast discretion to exempt trades from going through clearinghouses:
The 218-page Republican amendment differs from the Democratic bill by exempting more end users from requirements to send trades through clearinghouses. It would let regulators decide which derivatives would need to pass through clearinghouses…Unlike the Democratic bill, it would not mandate exchange trading for swaps.
According to Shelby, the bill will simply stipulate that “transactions will be ‘made known’ to regulators,” whatever that means.
At its core, the amendment is an attempt to leave the derivatives market as is: opaque, with a lack of information for investors looking for fair prices and regulators looking to enforce the rules. As the Roosevelt Institute’s Mike Konczal wrote, “the first axis by which to judge the financial reform of derivatives is to what degee derivatives are required to trade in clearinghouses…The second axis measures to what degree derivatives are required to trade in exchanges.” The GOP plan fails on both measures.
When it comes to complex financial instruments, the more information that investors and regulators have, the better the market is. The wide use of exchanges and clearinghouses will drive down prices, increase competition, and prevent the huge derivatives market from building up systemic risk.
Even former Treasury Secretary Hank Paulson feels this way, telling the Financial Crisis Inquiry Commission today that derivatives should be standardized and put on exchanges, and anything that is not standardized should have onerous capital requirements. “Such regulations will encourage standardization, promote transparency, and penalize excessive complexity with capital charges, thereby restoring these products to their proper function — mitigating, not enhancing, risk,” he said.