Final Derivatives Showdown Thursday: Read The House Offer
The long-awaited showdown between banks and Sen. Blanche Lincoln over her derivatives reform section of the Wall Street bill begins Thursday. The conference committee will consider an offer made by the House to amend Senate legislation that forces banks to spin off their swaps desk and separately capitalize that operation, while also bringing the business out into the open, requiring derivatives to be cleared and traded on exchanges.
However, one analyst identified an end-run the House may be attempting. Section 754 of the offer advanced by House Financial Services chairman Barney Frank (D-Mass.) says that "the Bank Holding Company Act of 1956 is amended by striking 'commodities activities' each place it appears and inserting 'commodities and swap activities,' which would make the swaps desks a 'functionally regulated subsidiary.'"
That would mean that a bank getting taxpayer assistance through the Federal Reserve window would still be required to spin off its swaps desk, but it could maintain it within a separate section of the bank holding company that isn't getting government assistance. "This is not as strong as a complete spinoff, but it still will have positive implications for the derivatives markets in the medium to long term," Adam White, director of research at White Knight Research & Trading, told HuffPost. White is a backer of Lincoln's original language.
The improvement would come because the big banks currently have a major competitive advantage in the swaps business: Everyone knows that they're "too big to fail," so that if they don't have the capital to pay off a losing bet, the government will step in and their counterparties will be paid. The smart move, then, is to trade with such banks. If the swaps desk were no longer part of the bank itself, but rather part of the bank holding company, the chance of a bailout is diminished, White said.
The Senate, however, has the upper hand, because its derivatives section is in the base bill. Both chambers would need to agree to the changes in order for the base bill to be tossed out.
If the Senate accepts the House changes, however, one of two things will happen, said Michael Greenberger, a University of Maryland professor and the former head of the Commodity Futures Trading Commission's Division of Trading and Markets. "Either we're going to have a bill that's regulation in name only or we going to have no regulation, which means no consumer protection infrastructure, no resolution authority and the whole of the benefits the reform provides," said Greenberger, who said he generally concurred with White's overall analysis, which can be found at the bottom of this story. Greenberger reasoned that if the House goes to far in weakening the derivatives portion, progressives in the Senate will vote against the bill on final passage, dooming it and the reform within it.
The House weakens the Senate legislation in a variety of ways that would lead to fewer trades being cleared and lower capital requirements. In many ways, said Greenberger, the House offer is even weaker than the version passed in December by the lower chamber.
Heather Booth, the head of Americans for Financial Reform, which is fighting for a strong bill, said that her organization believes Frank and Agriculture Committee chairman Collin Peterson (D-Minn.) do want tough reform, but are battling against the power Wall Street wields in the House. "We think Chairman Frank is trying to fight for strong reform and Chairman Collin Peterson is trying to fight for reform and they understand the riskiness of these speculative trades, and are very knowledgeable and very committed," but, she added: "For a variety of reasons, we think the Senate offer is much stronger than the House."
The House effort to gut Lincoln's reform is so extreme, said Greenberger, that enough progressives in the Senate would abandon the bill on a final vote and bring down reform altogether. Progressives often cave to centrist compromise under the reasoning that something is better than nothing. Covering some people with health insurance is, for instance, better than covering no people. But when it comes to Wall Street reform, something isn't always better than nothing. If the reform isn't tough enough and the same practices are allowed to continue through a variety of loopholes, the risk to the system and the size of the financial catastrophe that could occur may be no greater and no less with reform than without. The shame, said Greenberger, would be to lose valuable reforms such as the consumer financial protection bureau. But without real derivatives reform, he said, the country could experience another financial panic, leading to taxpayer bailouts, in as little as six months.
"It's one issue after the other where loopholes are created in an attempt to make the system unworkable and overly lax," Greenberger said. The argument that tough reform will send the derivatives business overseas is a false one, said Greenberger, speaking by phone from London where, he noted, our allies are crafting legislation much tougher on derivatives than the U.S. is even contemplating. "Germany is outright banning these risky products. The Asian countries, since the financial crisis in the nineties, are adamantly opposed," he said. "There's no place for Wall Street to go." He added that traders would pay a much higher tax rate anywhere else.
And if they do find somewhere to take explosively risky activity, he said, that's all for the better. "Better to have that kind of nuclear explosive activity take place abroad than the United States. The Europeans and the Asians are on to this and they're simply not going to allow it," he said. New York Democrats who worry about lost tax revenue are experiencing the "phenomenon of amnesia," apparently forgetting the huge holes slashed in state revenue by the 2008 financial crisis and the economic devastation it left in its wake.
Richard Trumka, president of the AFL-CIO, urged the conferees to adopt the Senate language. "Let me be clear: Any provisions or alternate language being offered are a gift to Wall Street. Financial regulatory reform without this strong derivatives language maintains the status quo where Wall Street gets rich on the backs of working families. We have to get it right or we set our nation up for another financial crisis. I do not say this lightly. Our future economy could very well rest on today's vote," he said, raising a particular objection to an expansion of the "commercial end user" exemption, which could allow hedge funds and insurers like AIG to escape regulation.
"The conferees must retain Section 716, which will require taxpayer-protected banks to move their risky derivatives trading operations into separately capitalized subsidiaries. This will protect taxpayers from losses in the $600 trillion derivatives market," he said. "Finally, critical technical fixes that Sen. Cantwell has pushed to include in the bill must be incorporated in order to ensure that regulators have full authority to go after people that intentionally evade derivatives regulation."
Notably, though, the changes are proposed by the House are made in slight ways, rather than as a broad attempt to remove the reforms entirely, meaning that Lincoln has won the public relations battle. Whether that means she can also win in the trenches and emerge with her reform in tact is a question that will be answered on C-SPAN Thursday.
The language of the House offer can be found here. Send observations and analysis to firstname.lastname@example.org or email@example.com.
Lincoln, a Democrat from Arkansas, introduced her legislation under pressure from a progressive primary challenger. She fended off the insurgency, but progressives were left with major swaps reform which is, against all odds, still alive.
House Financial Services Committee spokesman Steve Adamske says that the House didn't offer an amendment to Lincoln's section 716 because the House didn't have a corresponding section.
Democrats in favor of tough reform are entering the House debate that has been dominated the past week by the New Democrat Coalition and members representing New York state. Reps. Bart Stupak (D-Mich.), Rosa DeLauro (D-Conn.), and Jackie Speier (D-Calif.) began circulating a letter to conferees on Wednesday pushing back on the effort to weaken Blanche Lincoln's derivatives reform proposal.
By the end of the day, they'd gathered 50 signatures, giving House leadership a boost in its effort to persuade the New Democrats -- typically Wall Street friendly members from the suburbs -- to get in line behind a strong bill.
Below is an analysis to keep handy while watching the debate today. It was prepared by White, analyst who supports Lincoln's reform proposal:
HOUSE OFFER VS. SENATE BASE TEXT
BOTTOM LINE: THERE IS NO PROVISION OFFERED BY THE HOUSE THAT IS BETTER THAN THE SENATE, SOME WEAKEN A LITTLE, SOME WEAKEN A LOT, ALL SHOULD BE REJECTED.
RECOMMENDATION: REJECT THE HOUSE OFFERED AMENDMENTS IN EVERY KEY AREA. ACCEPT THE LYNCH AMENDMENT. [The Lynch amendment limits the concentration of ownership interest one firm can have in an exchange.]
KEY AREA RECOMMENDATION
Aggregate Position Limits: Reject
Clearing Requirements: Reject
Swap Dealer Definition: Reject
Major Swap Participant Definition: Reject
Swap Execution Facility Definition: Reject
Capital and Margin Requirements: Reject
Foreign Exchange: Reject
Section 716 "Swaps Dealer Push Out": No amendment offered
Duty of Care Language: Reject
AGGREGATE POSITION LIMITS
• House Offer does not include advisory panel of bona fide physical producers and consumers
• House Offer directs CFTC to set position limits at a level that does not lead to price discovery moving overseas and calls for a study of how much trading has moved overseas as a result of position limits. This study is a waste of precious time and resources and a bald attempt by the exchanges to argue they have lost price discovery because mega-speculators were limited in U.S. markets and chose to go overseas.
• House Offer codifies the "Swaps Loophole" into law, by granting swaps dealers the same status as bona fide physical hedgers.
• House Offer strikes Senate's better definition of Aggregate Position Limits, which uses the language "settles against, or in relation to" which is better than simply "settles against."
• House Offer strikes Senate base text which includes swaps traded on a Swap Execution Facility (SEF) under Aggregate Position Limits
• House Offer retains the term "balance sheet risk" which is unnecessary and only serves as a potential loophole for financial players such as hedge funds and others that have a balance sheet.
• The House Offer expressly prohibits a list of financial entities similar to the Senate base text approach. This list does not cover mutual funds, insurance companies and other financial players so that the inclusion of "balance sheet risk" will lead to financial players being exempted from clearing.
• It is good that the House moves in the Senate's direction BUT their Offer is still not as good as the Senate base text. The House argued that the Senate language was confusing and then they poached the Senate's language to beef up their language.
• House Offer strikes out Senate provisions that allow the CFTC and SEC to deem that swaps are clearable and to investigate when clearable swaps are not being cleared by the DCOs. It basically makes the "Cantwell Fix" unfixable so that DCOs and their Clearing Committees (which are dominated by Swaps Dealers) will be the sole determinants of what can be cleared.
• House Offer expressly forbids the CFTC and SEC from requiring a DCO to list a swap for clearing. This combined with anti-voiding provisions opens the door wide open for a complete end around of the clearing requirement.
• House Offer forces CFTC and SEC to look at a list of factors in determining whether or not a swap should be cleared. The only effect of this artificial list prepared by Congress is to reduce the number of swaps that are cleared. The ONLY determining factor should be "Is the swap clearable?" If the answer is yes, then it must clear.
DEFINITION OF SWAP DEALER
• House Offer contains a "De Minimis Exception" for people doing a de minimis amount of swaps dealing. This would be okay as long as it is a truly de minimis amount. In other words if this provisions allows BP to claim "our revenues are $100+ billion and our swaps dealing revenues are $5 billion so that's de minimis," then this is a bad provision. So fearing it could be abused it is better to not codify this possible loophole. The CFTC can certainly choose to offer a De Minimis Exception through rulemaking.
• House Offer does NOT take opportunity to add the phrase "to customers" after "purchase and sale of swaps" instead it adds a new definition to what constitutes a swap dealer: "regularly enters into swaps with counterparties as an ordinary course of business for its own account." This is very poorly worded because every swap in history is with a counterparty, so anybody regularly doing swaps in the ordinary course of business for their own account is now a swaps dealer. This would catch all kinds of non-dealers in the definition of swap dealer. "End-User" proponents should reject this because it makes them more likely to be caught in the swap dealer definition, not less.
FOREIGN EXCHANGE SWAPS
• House Offer strikes all of the Senate's superior provisions on Foreign Exchange swaps and forwards so that they are 100% exempt from regulation.
DEFINITION OF MAJOR SWAP PARTICIPANT
• House Offer does not mention the word "net" as in "substantial net position" instead it retains the Senate's "substantial position" which is good. Also House Offer removes unilateral exemption for pension plans, which is good.
• House Offer modifies "highly leveraged financial entity" to exclude Federally regulated banks which is okay.
• House Offer would be better than the Senate if it were not for the following additional language which was added: "In setting the definitions, the Commission shall consider the person's relative position in uncleared as opposed to cleared swaps and may take into consideration the value and quality of collateral held against counterparty's exposures." This is a moving target so that someone could clear most of their swaps and hold high quality collateral on the rest in order to avoid being labeled as a Major Swap Participant and then, when the review is over, stop clearing their swaps and stop requiring high quality collateral. This restriction on regulators should not be part of their determination of who is a Major Swap Participant. At the end of the day the only thing that matters is if someone is systemically significant or they are not. It does not (and should not) matter if they are at that moment in time clearing a high percentage of their swaps and holding high quality collateral.
DEFINITION OF SWAP EXECUTION FACILITY
• House Offer uses the term "voice brokerage facility" which opens the door for a telephone to be considered an exchange or SEF. This is not good.
• House Offer strikes the Senate's use of the word "multiple," which is a necessary precursor to a telephone becoming an exchange since generally there are not multiple customers talking on the line at one time.
CAPITAL AND MARGIN REQUIREMENTS
• House Offer strikes out Senate's mandate that uncleared swaps must face capital and margin that is "substantially higher" than the requirements for cleared swaps. This defeats a key policy tenet of the Obama Administration and one that Barney Frank has endorsed himself.
• House Offer strikes the Senate's mandate that regulators should assess capital and margin for swaps dealers and major swaps participants based on all their swaps exposures and instead forces regulators to limit capital and margin requirements to just those areas in which they are determined to be a "swap dealer" or "major swap participant." So if a bank is considered to be an interest rates swap dealer then they do not face capital or margin for their credit default swaps, equity swaps, commodity swaps or foreign exchange swaps (which are exempted anyway).
DUTY OF CARE
• The Senate base text says that a dealer has a heightened duty of care when the dealer solicits a trade, recommends or offers advice with regard to a transaction with a special entity, whereas the House duty would only apply when the dealer acts as an advisor. As a result, recommendations by swaps dealers could escape the heightened responsibility, just as recommendations by securities brokers have escaped the fiduciary duty that applies to investment advice.
• The Senate language would require a dealer offering a swap to a pension fund or municipality to have reasonable grounds to believe the swap is in the best interest of its counterparty. The House says acting as an advisor requires making reasonable efforts to obtain information necessary to make a reasonable determination that any swap recommended by the dealer is in the best interest.
• The Senate also has more comprehensive disclosure requirements including fee disclosures. The House fails to include important disclosures.