THE BLOG
03/18/2010 05:12 am ET | Updated May 25, 2011

Derivatives Regulation: The Devil in the Details

The House of Representatives has begun the debate on the Wall Street Reform and Consumer Protection Act... (HR 4173)

The real devil lurking in the details is the regulation of derivatives...

The weeds of the competing legislative proposals are a little thick but the high level concept relates to where the derivatives trade gets done...

Will the trade get done in the light or in the dark?

Will the trade get done on a public exchange or alternative swap facility?

Or will it be done during a phone call between two big banks and then buried deep in an opaque trading book? Where it will lurk as a weapon of mass destruction as Warren Buffett would say

Derivatives trading must happen in the light...

These trades must be done publicly to provide stability in our financial system...

Remember the AIG darkness? Which almost melted down the global economy... it was really dark around all those AIG trades... dark as a graveyard.

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Here are the particular details where the devil is lurking... from Baseline Scenario:

Colin Peterson (D-MN), Chairman of the House Committee on Agriculture, along with Barney Frank, has added an amendment to the OTC Bill (opens large pdf). There are two relevant sentences for reformers from the long document. The first is on page 32:

(49) SWAP EXECUTION FACILITY.--The term 'swap execution facility' means a person or entity that facilitates the execution or trading of swaps between two persons through any means of interstate commerce, but which is not a designated contract market, including any electronic trade execution or voice brokerage facility.

This replaces other language in the original bill (opens even larger pdf), on page 546:

SEC. 5h. SWAP EXECUTION FACILITIES.
(a) REGISTRATION.--
(1) INGENERAL.--
(A) No person may operate a swap execution facility unless the facility is registered under this section.

(B) The term 'swap execution facility' means an entity that facilitates the execution of swaps between two persons through any means of interstate commerce but which is not a designated contract market.

So notice any differences? First the definition of a swap execution facility has been expanded to include "a person" (different from the "or entity"). It's also expanded to an "or trading" definition, and includes voice brokerage firms. So now we are moving from the definition of something that is a platform for swaps to be traded on to instead something that simply helps swaps get traded. This could, quite simply, be a telephone over which two people trade a derivative (with one person declaring himself to be the exchange?). Instead of changing the way business is done for reform it looks like it redefines reform as the way things are currently done, and just calls it a victory.

Now on page 89 of the amendment:

2) RULES FOR TRADING THROUGH THE FACILITY.--Not later than 1 year after the date of the enactment of the Derivative Markets transparency and Accountability Act of 2009, the Commission shall adopt rules to allow a swap to be traded through the facilities of a designated contract market or a swap execution facility. Such rules shall permit an intermediary, acting as principal or agent, to enter into or execute a swap, notwithstanding section 2(k), if the swap is executed, reported, recorded, or confirmed in accordance with the rules of the designated contract market or swap execution facility.

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Here are all the amendments that are being debated on the floor:

The 'manager's amendment' is a kitchen-sink amendment that pulls in all the last minute deals (so you can actually see handwriting on the PDF). It is 242 pages long and that is where you are going to find a lot of important policy changes.