BUSINESS
05/21/2010 05:25 pm ET | Updated May 25, 2011

Gary Gensler, Top Regulator, Says Some Derivatives Should Be Illegal

In a move that could rattle Wall Street and upset bank-friendly Democrats, the top federal regulator overseeing much of the derivatives market says that some swaps should be illegal.

In a little-noticed comment during a Senate Banking Committee hearing on Thursday, Commodities Futures Trading Commission Chairman Gary Gensler said that he agreed with a proposed amendment to the Senate's financial reform bill that would void those derivatives contracts that purposely evade mandatory clearing requirements.

The amendment would deem such contracts unenforceable if the parties to a swaps contract -- a type of derivative that involves regular payments over a specified time period -- knowingly avoid a clearinghouse. The legislation mandates that standard swaps contracts go through a clearinghouse, a facility that executes trades for parties that are required to post collateral and mark their positions daily to prevailing market prices.

The bill "right now gives the SEC and CFTC a lot of authority, but to be clarified to say that that transaction is unlawful seems consistent with actually what the intent is," Gensler said in response to a question posed by Sen. Jack Reed, a Rhode Island Democrat.

That clarifying provision, proposed by Democratic Senators Maria Cantwell, of Washington, and Blanche Lincoln, an Arkansan who oversees the CFTC as chairman of the Senate Agriculture Committee, tries to plug what's been referred to as a loophole. The legislation in its current form preserves the legal certainty of these financial instruments, which are used by firms to hedge against risk and for speculation.

The bill "states that a swap that does not clear may not be deemed void or unenforceable. The lack of an express ban on uncleared swaps... converts the clearing requirement into a mere suggestion," argues an email obtained by the Huffington Post that was sent last week by consumer advocacy group Americans for Financial Reform to a Senate Banking Committee staffer.

In other words, those swaps that do not trade via a clearinghouse when they're supposed to can't be deemed invalid because of this evasion, the effect of which could entice parties to evade clearinghouses and continue trading with one another in an unregulated shadow market because they'd know those contracts would be enforced in a court of law.

"The derivatives market is where a lot of the big, risky financial bets by companies like AIG took place," President Barack Obama said on April 16. "There are literally trillions of dollars sloshing around this market that basically changes hands under the cover of darkness. When things go wrong, as they did in AIG, they can bring down the entire economy, and that's why we've got to bring more transparency and oversight when it comes to derivatives and bring them into a framework in which everybody knows exactly what's going on, because we can't afford another AIG." The president added that he would veto legislation that "does not bring the derivatives market under control."

The Senate legislation, championed by the Obama administration and Senate Banking Committee Chairman Christopher Dodd, passed Thursday by a 59-39 vote. Cantwell was one of two Democrats to vote against it.

"While this bill takes much needed steps to help prevent a crisis of this magnitude from ever happening again, it fails to close the very same loopholes in derivatives trading that led to the biggest economic implosion since the Great Depression," Cantwell said in a statement. "[W]ithout key reforms in derivatives trading, this bill does not safeguard America's economy from a repeat of this crisis... I fear that without closing the loopholes primarily responsible for this economic meltdown, we are missing the entire heart of the matter."

Mandatory use of clearinghouses would end the current practice of financial firms trading with each other with no oversight. It would shed more light on the market and allow for government regulators to more effectively police it, regulators and Obama administration officials argue.

Those against Cantwell's and Lincoln's amendment argue that it would introduce too much uncertainty into the market. Also, the CFTC has wide authority to write new rules governing evasion and it can levy an assortment of fines and penalties on those who purposely don't comply with the law.

Those wishing to fully clean up the derivatives market retort that by making these swaps illegal, thus void and unenforceable, it would act as a much more powerful deterrent to bad actors wishing to evade the law.

Though the Senate did not vote on the amendment before voting to pass the overall bill, it could still find its way into the final legislation.

The Senate bill must be merged with the House financial reform bill, which was passed in December. That merger would occur during what's known as a "conference committee" -- a panel of legislators from the House and Senate who hammer out differences before both chambers vote on an identical bill to be sent to the president. Cantwell's amendment could get in during the conference committee.