Next week, Congress returns from its Memorial Day recess, meaning that the conference committee that will reconcile the House and Senate versions of financial regulatory reform will begin to meet. And one of the most contentious areas will be reform of derivatives, the instruments that played a large role in the collapse of many large financial firms, most notably AIG.
Successful derivatives reform will be achieved if a significant amount of trading is forced to go onto public exchanges (like those used for stocks) and through clearinghouses (which act as middlemen, ensuring that both sides have adequate collateral). On this measure, the Senate bill is stronger, as it forces all standardized derivatives onto exchanges and puts all customized derivatives through clearinghouses. There are exemptions for non-financial companies, which allow them to avoid the requirements, but they are narrow in scope.
The House bill, meanwhile, has much wider exemptions, which has led the banking industry — and its allies at the Chamber of Commerce — to push for the House language, and argue that more, larger exemptions are in order. Yesterday, Gary Gensler, the Chairman of the Commodity Future Trading Commission (which polices derivatives), weighed in strongly against those exemptions, saying that they will “come back to haunt us in the future”:
Language in the House bill may be read to provide for a more liberal exemption for entities using derivatives to hedge commercial, balance sheet or operational risk, which could leave a larger class of transactions out of a clearing requirement – including those between two financial entities…Every exemption for financial companies creates a link in the chain between a dealer’s failure and a taxpayer bailout. Every slice of the financial system that we cut out through an exemption could allow one bank’s failure to spread like fire throughout the economy. It is essential that financial reform does not allow loopholes that leave interconnectedness in the system. Such exemptions will only come back to haunt us in the future.
Even House Financial Services Chairman Barney Frank (D-MA), who ushered the bill to passage in the lower chamber, isn’t pleased with the language. “I am not defending what we passed in the House,” he said. “I lost on a couple of votes that, if we were doing them now with the public attention we are getting without health care, we would have won.”
The overwhelming majority of derivatives trading is between financial firms, with no legitimate end-user hedging any risk (which is the whole reason for which derivatives were created). In fact, five large banks — JP Morgan Chase, Goldman Sachs, Bank of America, Citigroup, and Wells Fargo — account for 97 percent of the activity. The more exemptions exist, the easier it will be for these financial companies to exploit them. And in the end, a transparent marketplace that is free of fraud — which exchanges and clearinghouses help to create — will drive down prices of derivatives for companies that actually need them.