One of the legitimate criticisms of the Dodd-Frank financial regulatory reform bill that passed this year is that it leaves a lot of the details of reform up to regulators, instead of laying out hard-and-fast rules. There are pros and cons to this approach, but one of the big drawbacks is that the rule-making happens when the subject has faded from public view, giving the financial services industry even more influence over the process than it already has.

Case in point, the country’s biggest banks have been meeting with officials at the Federal Reserve in an attempt to shape the new rules governing derivatives trading:

Goldman Sachs Group Inc., Citigroup Inc. and others have also discussed tough rules for derivatives with government officials. Citi executives, meeting with the Fed on Aug. 18, expressed concerns about the effect of the new rules on U.S. firms. “Citigroup representatives also expressed concerns about a narrow interpretation of the definition of hedging and the importance of retaining their ability to hedge across markets,” the meeting summary prepared by the Fed said.

Non-financial companies and lobbying groups are also trying to influence the new derivatives rules, including the American Petroleum Institute and the U.S. Chamber of Commerce.

First, I’m glad to see that these meetings were disclosed relatively quickly. Other bank regulators, including the FDIC, have been planning to make a concerted effort to disclose their meetings with private sector representatives regarding the implementation of Dodd-Frank, and it’s good to see the Fed follow suit.

But on to the substance. The derivatives title of Dodd-Frank is one of the better parts of the bill, bringing much-needed transparency to an unregulated market and restricting some of the riskier derivatives trading in which banks can engage, by forcing them to move certain activities into a separately capitalized subsidiary (although this provision was watered down from a much-stronger one at the very last minute). But activities that qualify as related to hedging risk don’t have to be walled off.

Therefore, it’s in the banks’ interest to have as much activity as possible qualify as hedging, which is what these meetings seem to have been about. But the wider these definitions are, the less effective Dodd-Frank is going to be and the more risky trading will occur in the heart of the financial system. The added lobbying of the Chamber and API, which both falsely portrayed the effect that financial regulation would have on corporations while negotiations were ongoing, is only going to tip the scales in favor of a wider definition and more risk in the system.

If regulators don’t craft strong rules during this implementation stage, financial reform isn’t going to amount to much. And, sadly, there’s no logical counterweight that has as much at stake in the discussion.

This week, Pat Toomey, Pennsylvania’s Republican Senate candidate, has experienced a bit of selective amnesia regarding his often full-throated support for privatizing Social Security. However, on the campaign trail Wednesday he was not at all coy about his support for deregulating derivatives on Wall Street, the very instruments that helped bring down the financial system.

In 2000, former Sen. Phil “mental recession” Gramm (R-TX) attached the Commodity Futures Modernization Act to an unrelated, 11,000 appropriations bill which was passed “on a Friday evening two days after the Supreme Court handed down its Bush v. Gore ruling and as Congress was rushing home for Christmas.” The bill ensured that the growing market in over-the-counter derivatives, including credit default swaps, stayed entirely unregulated, against the advice of people like former Commodity Futures Trading Commission Chair Brooksley Born (who accurately predicted the havoc derivatives would cause).

Toomey — then a member of the House of Representatives — voted for that bill, and said that he would do it again, as “that bill did absolutely nothing to cause the financial crisis”:

“That bill did absolutely nothing to cause the financial crisis, and no credible person has tried to make that argument,” Toomey said…Asked whether he’d vote for it again, he said: “Yes. I think all 377 (House members) would vote for it again.”

Of course, plenty of credible people — including Nobel Prize winner Joseph Stiglitz — have pointed to the destruction wrought by the lack of derivatives oversight. By keeping regulators away from the OTC derivatives market — which is several times the size of the entire U.S. economy — the Commodity Futures Modernization Act set the stage for the financial crisis and huge government bailouts of 2008, particularly that of the insurance giant/hedge fund American International Group, as David Min and I explained:

Lehman Brothers Inc. and insurance giant American International Group’s inability to honor their many billions of dollars in credit default swap derivative obligations caused investors to question the value of the many financial instruments tied to credit default swaps, causing a classic run on the bank situation for the unregulated parts of the financial system. It was this run on the so-called “shadow banking system” — which performs the functions of banking but outside the regulatory safeguards in place for banks — that led to the bailout of AIG.

Because of the bill that Toomey backed, this huge market grew and grew entirely out of the view of regulators, and was so opaque that even the financial institutions involved in it were unclear as to what was going on.

The Dodd-Frank financial reform bill that was signed into law this year brings the derivatives market out of the dark and sets up a mechanism for ensuring that financial firms trading derivatives have adequate collateral backing them up. So would Toomey advocate that we dismantle these common sense safeguards?

In the 1990′s, Brooksley Born, who chaired the Commodity Futures Trading Commission at the time, tried to warn federal bank regulators, including Federal Reserve Chairman Alan Greenspan, about the dangers of over-the-counter derivatives. To put it mildly, her alarm-sounding did not go over well:

Born’s proposal stirred an almost visceral response from other regulators in the Clinton administration, as well as members of Congress and lobbyists. The economy was sailing along, and the growth of derivatives was considered a sign of American innovation and a symbol of the virtues of deregulation. The instruments were also a growing cash cow for the Wall Street firms that peddled them to eager takers. Ultimately, Greenspan and the other regulators foiled Born’s efforts, and Congress took the extraordinary step of enacting legislation that prohibited her agency from taking any action.

Of course, as we now know, the huge, opaque derivatives market helped to unleash a financial cataclysm, particularly by imploding the insurance giant AIG. “No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing,” Born said. “There was also little or no capital being put up as collateral for the transactions.”

Since Born saw the problems with the derivatives market where so many others didn’t, it’s significant that she has lent her support to the financial regulatory reform package that passed the House this week and is due for a vote in the Senate when the July 4th recess ends. “[The bill] is an important step forward in regulating the over-the counter derivatives market and I very much hope it is enacted into law,” Born said.

Despite the unfortunate watering down of the provision forcing banks to spin their derivatives trading desks into separately capitalized entities, the derivatives title of the Dodd-Frank financial reform bill is quite strong. It places standardized derivatives trades onto public exchanges (like the stock exchange) and forces customized trades to be cleared by clearinghouses (avoiding an AIG-type situation where one party to a trade has insufficient capital on hand to back it up). This is getting lost in the drama surrounding Sen. Scott Brown’s (R-MA) hemming and hawing over the bill, but it’s an important set of reforms that needs to become law.

Early this morning, the conference committee reconciling the House and Senate versions of financial regulatory reform approved final language for the legislation after a marathon 20 hour negotiating session. The House conferees approved the reconciled legislation on a 20-11 vote and the Senate approved it 7-5. Both votes were party line. The bill now moves to one more vote in each chamber next week, where it can’t be amended further.

A flurry of changes were made to the legislation last night, including the addition of an exemption to the Volcker rule — a ban on banks trading for their own benefit with federally insured dollars — and a weakening of Sen. Blanche Lincoln’s (D-AR) provision requiring banks to spin-off their derivatives trading desks. However, the final bill seems to have retained Lincoln’s language requiring exchanges and clearinghouses for derivatives, as well as a provision from Sen. Susan Collins (R-ME) that compels banks to hold more capital against losses.

Below is a comparison of the House and Senate versions of the bill, as well as what ultimately ended up in the conference report. This is by no means an exhaustive comparison, but hits the major portions of the bill:

Provision	Senate Bill	House Bill	Reconciled Bill
Derivatives Exchanges and Clearing	Forced almost all derivatives trading onto exchanges and through clearinghouses, with narrow exemptions for non-financial end users.	Forced derivatives trading onto exchanges and through clearinghouses, but with wide exemptions for end-users, including financial companies.	Senate version
Derivatives Spin-Off	Forced banks to spin-off their derivatives trading desks into a separately capitalized entity.	Did not include a spin-off provision.	Forces banks to spin-off some derivatives trading activity (commodities, energy, metals, agriculture, equities and below-investment-grade credit default swaps) but keep trading related to interest rate swaps, foreign exchange swaps, credit, gold and silver, investment-grade credit default swaps and “any transaction used to hedge risk.”
Volcker Rule	Directed regulators to study and then implement a ban on proprietary trading.	Allowed regulators to ban proprietary trading at systemically risky firms.	Implements a stronger ban proposed by Sens. Carl Levin (D-MI) and Jeff Merkley (D-OR), but with an exemption sought by Sen. Scott Brown (R-MA) that allows banks to invest up to three percent of their Tier 1 capital in risky hedge funds and private equity firms.
Consumer Protection Agency	Included a Consumer Financial Protection Bureau, housed within the Federal Reserve, with an independent director and rule-writing authority. It could be overruled by a majority vote of the Financial Stability Oversight Council, which is composed of bank regulators.	Included a stand-alone Consumer Financial Protection Agency with an independent director and rule-writing authority.	Senate version
Auto Dealer Exemption	Did not exempt auto dealers from oversight by the new consumer regulator, but the Senate did pass a “motion to instruct” encouraging conferees to approve the House language.	Exempted auto dealers from oversight by the new consumer regulator.	House version
Resolution Fund	Included resolution authority funded by an after-the-fact assessment on large financial institutions. Any extra money needed to unwind a firm can be fronted by the Treasury Departent.	Included resolution authority pre-funded by an assessment on institutions with more than $10 billion assets. The fund could grow no larger than $150 billion.	Senate version

“This is going to be a very strong bill, and stronger than almost everybody predicted that it could be and that I, frankly, thought it would be,” said House Financial Services Chairman Barney Frank (D-MA). The legislation was renamed the Dodd-Frank bill after Frank and Senate Banking Committee Chairman Chris Dodd (D-CT).

Today, the conference committee that is reconciling the House and Senate versions of financial regulatory reform is supposed to deal with one of the most contentious aspects of the legislation: reform of the derivatives market. The Senate’s text, which is being used as the base for negotiations, includes a strong derivatives title authored by Sen. Blanche Lincoln (D-AR) that would force almost all derivatives trades onto public exchanges (like the stock exchange) and through clearinghouses (which ensure that each party in a trade has adequate collateral should the trade go bad).

Lincoln’s bill also includes Section 716, which is a provision requiring banks to place their derivatives trading desks into a separately capitalized entity. It has drawn the scorn of the financial services industry, but would help protect taxpayers by ensuring that risky derivatives trading is divorced from money that is federally insured (like a bank’s deposits).

In the last few days, some House Democrats have expressed hesitation about Section 716, with one, Rep. Mike McMahon (D-NY), saying that “it would be impossible for me to vote for a bill that contains that provision.” Lincoln has, thus far, been standing tall against pressure to back down, and yesterday received some support from one of the few Republicans who voted for financial reform — Sen. Chuck Grassley (R-IA):

“I heard there was some compromise or some backing down on Blanche Lincoln’s part, and I hope she doesn’t back down,” Grassley said. “I voted for it in the Ag Committee, and it’s one of the main reasons I voted for it on the floor of the Senate.”

And while much has been made of the Democrats who are reluctant to support Lincoln, there are also House Democrats who are pushing for Section 716 to remain in the final bill. Reps. Bart Stupak (D-MI), Jackie Speier (D-CA) and Rose DeLauro (D-CT) penned a letter to the financial reform conferees telling them to “preserve the strong Senate language”:

The Senate bill includes important provisions that remove the ongoing Federal subsidy to the derivatives businesses of the five large banks that dominate this market. This language will help ensure that taxpayers are not supporting this risky activity with deposit insurance or other benefits. It will increase transparency and safety by making sure that derivatives market making activities are separately capitalized. As a result, it will also redirect bank capital towards lending and investment in Main Street, rather than empty speculation.

Rep. Barney Frank (D-MA) said earlier this week that “the essence of what Senator Lincoln wanted to do on pushing derivatives out of the banks will happen, and certainly they will be totally insulated from any insured deposits.” It seems this is one of the few ideas recently capable of garnering bipartisan support.

When she’s not looking to weaken capital requirements for the benefit of her state’s biggest bank, Sen. Blanche Lincoln (D-AR) has been doing good work on financial regulatory reform, as she authored a title on derivatives reform that is stronger than its House counterpart, and would help bring transparency to this currently opaque market.

Lincoln’s title is worthwhile because it forces almost all derivatives trades onto public exchanges (like the stock exchange) and through clearinghouses (which ensure that each party in a trade has collateral should the trade go sour). These steps help both investors and regulators see what is happening, driving down prices and making it easier to police financial shenanigans.

But Lincoln’s bill also includes what’s known as Section 716, which would require banks to place their derivatives trading desks in separately capitalized entities, divorced completely from the banks’ federally insured deposits. House Financial Services Chairman Barney Frank (D-MA), who is also chairing the ongoing financial reform conference committee, had initially expressed opposition to the measure, saying that it “goes too far,” but he is now saying that Lincoln’s goal of getting derivatives away from traditional banking “will happen”:

The essence of what Senator Lincoln wanted to do on pushing derivatives out of the banks will happen, and certainly they will be totally insulated from any insured deposits.

The financial services industry is fighting the spin-off provision tooth and nail, and it’s really no surprise considering that “selling over-the-counter derivatives is among the most lucrative businesses for the largest financial companies.” In fact, U.S. banks held derivatives with a notional value of $212.8 trillion in the fourth quarter of last year. JP Morgan, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley hold 97 percent of that amount. BusinessWeek estimated that JP Morgan and Citigroup have the most to lose from Lincoln’s provision:

JPMorgan had 98 percent of its $142 billion in current value derivatives holdings inside its bank in the first quarter of this year while Citigroup had 89 percent of $112 billion, the records show…Morgan Stanley and Goldman Sachs Group Inc., each of which entered the commercial banking business in 2008 in the midst of the financial crisis, would be less affected. Morgan Stanley kept just over 1 percent of its $86 billion in derivatives holdings in its bank in the first quarter, and Goldman Sachs Group’s held 32 percent of its $104 billion.

As Kansas City Federal Reserve President Thomas Hoenig and Dallas Federal Reserve President Richard Fisher wrote, that kind of risky trading “should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk.” And it’s looking more and more like such a division could actually become the law of the land.

Yesterday, the conference committee reconciling the House and Senate versions of financial reform really got underway, with the first amendments being offered (and then counter offered). One item that has not yet been placed onto the docket though is derivatives reform, particularly the provision authored by Sen. Blanche Lincoln (D-AR) that would require banks to places their derivatives trading desks into separately capitalized entities.

Lincoln’s spin-off provision, known as Section 716, has been slowly receiving support from a variety of players in Washington, including Senate Banking Committee Chairman Chris Dodd (D-CT), who said “at this point, I’m in support of what she has in the bill.” This week, former Federal Reserve Chairman Paul Volcker, who initially opposed Lincoln’s plan, said that “it may be useful in some cases to have particular activities separated out.”

However, not everyone is jumping on board. The New Democrats, a band of bank and Big Business friendly House Democrats, have drafted a letter not only arguing against Section 716, but pushing for the conference to adopt the House’s loophole ridden derivatives reform, instead of the Senate language:

The New Dems worked to craft legislation that dramatically increases oversight, accountability and transparency in the derivatives market, where the inability of regulators and the private sector to evaluate existing risks exacerbated the financial crisis…The House also provided clear protections for end users who pose no risk to the stability of the financial system so they may continue to use derivatives to prudently manage their risks.

The letter adds “we believe Section 716 should be removed from the legislation.” According to Politico, the driving force behind the letter is Rep. Michael McMahon (D-NY), who has also argued for the extension of the Bush tax cuts for the wealthy on the grounds that people making $250,000 per year are “barely making ends meet.”

Contrary to the New Democrats’ assertion, the Senate’s derivatives language is much stronger, as the House crafts overly broad exemptions to the requirements that derivatives henceforth be traded on exchanges or put through clearinghouses. As Commodity Futures Trading Commission Chairman Gary Gensler has said, “language in the House bill may be read to provide for a more liberal exemption…Every exemption for financial companies creates a link in the chain between a dealer’s failure and a taxpayer bailout.”

Section 716, meanwhile, has now earned the support of three Federal Reserve Bank Presidents. Last week, Kansas City Federal Reserve President Thomas Hoenig and Dallas Federal Reserve President Richard Fisher wrote in a letter supporting Section 716 that the risks associated with derivatives trading “are generally inconsistent with the funding subsidy afforded institutions backed by a public safety net. Such activities should be placed in a separate entity that does not have access to government backstops.” According to a Lincoln aide, St. Louis Federal Reserve President James Bullard also supports the provision.

Lincoln, for her part, is still going all-out for her bill. “I don’t disagree at all that there’s a very real need to be able to manage risk — we don’t take that away,” she said. “We just simply say that if you’re going to be the dealer of that risk, you have to separate that dealership risk outside the bank…You need to capitalize it for the true risk that it is and not let that risk be left on the backs of taxpayers and on bank depositors.”

As the conference committee reconciling the House and Senate’s respective financial regulatory reform bills gets down to business this week, it will be starting with the Senate’s text as the base. When it comes to crafting a regulatory regime for derivatives — the risky instruments that played a large role in the economic crisis, and particularly in the downfall of AIG — this is a good thing, as the Senate bill is much stronger.

Strong derivatives reform will place as much derivatives trading as possible onto public exchanges (like that used for stocks) and force all customized trades that can’t go onto an exchange through a clearinghouse (which ensures that both sides of the trade have adequate collateral). The trouble with the House bill is that it contains a whole host of exemptions to the exchange and clearing requirements, which could allow financial companies that are only using derivatives to speculate to slip through, unregulated.

The financial services industry would, of course, like as many loopholes as possible to exploit down the road, and thus is trying to widen the exemptions. And House Republicans have been all too willing to play along, as evidenced by Rep. Spencer Bachus’ (R-AL) performance yesterday on C-Span’s Newsmakers.

Bachus made sure to pay lip service to the fact that “there needs to be disclosure, there needs to be transparency” when it comes to derivatives, but he then expressed shock that Democrats want to put trading onto exchanges, claiming that doing so “fixed things that weren’t a problem.” Watch it:

Of course, the way in which you bring transparency to the derivatives market is by, you guessed it, moving trading onto exchanges. Exchange trading ensures that both buyers and sellers know what the going rate for a particular product is, and leaves an easy trail for regulators to follow if there is fraud or abuse. Bachus, meanwhile, seems to want to implement transparency by waving a magic wand.

Bachus is using the same tactic that the right-wing has employed throughout the debate over derivatives, singling out end-users (non-financial corporations that legitimately use derivatives to hedge risk) as the poster-children for increased regulation. But remember, 97 percent of derivatives are held by just five mega-banks and there are $78 dollars in derivatives for every single dollar that is used by a company to hedge against risk.

A transparent, functional marketplace that fully utilizes exchange trading will actually bring prices down for the very companies that Bachus is expressing such concern for. And as Commodity Futures Trading Commission Chairman Gary Gensler explained, “exemptions will only come back to haunt us in the future”:

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.

If Bachus has a better idea, I’d love to hear it, but you can’t just snap your fingers and turn an opaque, non-functional market into a transparent one.

One of (if not the) most reviled portions of financial regulatory reform for the banking industry is a provision authored by Sen. Blanche Lincoln (D-AR) that would require banks to spin-off their derivatives trading desks into separate entities, with their own capital, or lose their access to federal insurance. Sec. 716 has not only caused the banks consternation, but has garnered the opposition of the Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corp.

For months, the financial services industry has been assuming that the provision would be stripped out of the legislation, first on the Senate floor and then in conference committee. However, according to the Financial Times, the banks are readying themselves to ultimately lose this debate, as former Federal Reserve Chairman Paul Volcker — who has been a key player in the regulatory reform fight — has softened his initial criticism of Lincoln’s measure:

Defeat, which would be a further blow to Wall Street, has been made more likely by Paul Volcker, the influential former Federal Reserve chairman, softening his opposition to the provision…Although he declined to say whether he now supported it, Mr Volcker told the Financial Times that his earlier criticism was based on the belief that a stricter spin-off was in the works and it was now a “relevant question” whether damage would be done if swaps desks could be kept within a bank holding company. “I tend to think of the bank holding company as the relevant organisation,” he said.

As David Dayen put it at Firedoglake, “I see nothing here to guarantee the preservation of Section 716. But this is clearly a crack in the establishment, which lined up quickly and united their opposition to the measure.” Indeed, with the regulators all weighing in against it, it will still be a heavy lift to get the provision into the final bill, but Volcker saying that it could be workable is undeniably a boost, as is the support of Kansas City Federal Reserve President Thomas Hoenig, who said last week that trading in derivatives is “generally inconsistent with the funding subsidy afforded institutions backed by a public safety net.”

This provision means real money for the biggest banks, particularly Bank of America and JP Morgan, so they’ve been “apoplectic” about it. But they’re dealing with both the economic argument for the spin-off, which rightly asserts that banks should not be able to benefit from a federal backstop while trading in risky instruments for their own benefit, and the political reality that Lincoln has a tough reelection campaign coming and needs to score some legislative victories.

Volcker’s softening reflects the reality that the spin-off provision would not prevent banks from hedging risks via derivatives (like early reporting said it might), but only from making markets. In fact, that’s one of the more attractive features of the spin-off: the banks will become customers in the derivatives market, so they’d have as much incentive as anyone else in creating a functional market with low prices.

Volcker said that he is canceling his summer vacation to be on-hand to provide advice to lawmakers as financial reform enters its endgame. “Normally I go to Canada — where the banking system is all healthy and straightforward,” he said.