Members of Congress Speak Out To Protect Derivatives Reforms

Four years ago, with the passage of the Dodd-Frank financial reform law, Congress established basic standards of safety and transparency for the massive and previously unregulated derivatives markets that played a central role in crashing the world economy. Now nineteen current and former legislators involved in drafting that legislation, led by former Representative Barney Frank, are speaking out to oppose Wall Street’s efforts to do an end-run around the law.

 The question at issue is whether U.S. derivatives rules will govern transactions conducted through nominally overseas entities, like foreign subsidiaries of U.S. banks, or foreign banks who are key players in the U.S. derivatives markets. This is a critical question because the largest global banks can shift derivatives risks and funding between thousands of international subsidiaries at the touch of a computer keyboard. Nominally, a transaction may be booked in a foreign subsidiary, incorporated in the Cayman Islands or Hong Kong, but the risk and economic impact remain with the U.S. economy. It’s impossible to effectively regulate derivatives markets without applying rules to transactions conducted through foreign subsidiaries.

In fact, if you’ve read about a major scandal involving derivatives, chances are foreign subsidiary transactions were at the center of the affair. In the 1990s, Long Term Capital Management almost brought down Wall Street with trillions in derivatives traded through Cayman Islands subsidiaries, and in Britain the 230 year-old Barings Bank failed thanks to the actions of a single rogue derivatives trader. During the financial crisis, AIG’s London subsidiary, AIG Financial Products, experienced massive derivatives losses that resulted in a U.S. taxpayer bailout. And even more recently, the London Whale created billions of dollars in losses for JP Morgan through London derivatives trades.

No one understands all this better than the major Wall Street banks, who routinely conduct over half of their derivatives transactions through foreign subsidiaries. That’s why as the Commodity Futures Trading Commission (CFTC) finally begins to implement Dodd-Frank derivatives rules, the major Wall Street derivatives dealers are trying a last minute end run around derivatives enforcement. Their vehicle is a major lawsuit that seeks to stop the derivatives regulation in its tracks by banning any cross-border enforcement of any Dodd-Frank derivatives oversight. Arguing that the CFTC has failed to comply with technical procedural requirements for economic analysis, a few global mega-banks are asking the court to forbid the agency from enforcing any of the Dodd-Frank derivatives and commodity market reforms at foreign subsidiaries of U.S. banks, or foreign banks operating in the U.S. If they get everything they’re asking for, dozens of rules that took years to complete will be rendered almost impossible to enforce, until elaborate new rulemaking procedures are completed for each and every rule. That would add fresh years of delay to the three and a half years we’ve already waited for real derivatives oversight.

But there’s at least one major problem with their argument: Congress also understood the danger of cross-border evasion of derivatives rules, and ensured that the CFTC has clear jurisdiction to address it. Specifically, Section 722(d) of the Dodd-Frank Act states clearly and unambiguously that any CFTC derivatives rule governs not just transactions conducted on U.S. soil, but also any nominally foreign transaction that has a ‘direct and significant’ connection with U.S. commerce. 

Now Congress is speaking up against Wall Street’s attempt to use procedural technicalities to dodge this clear statutory rule. Today, nineteen current and former Representatives and Senators, led by former representative Barney Frank, a lead drafter of the Dodd-Frank Act, filed an amicus brief opposing the big banks’ case. Their brief makes a conclusive case for Congress’ intent to properly regulate all derivatives that impact the U.S. economy – even those that take an end run through a foreign country. Let’s hope that this strong statement by Congress leads the court to push back the bank’s attempt to get out of the rules.

Why You Should Pay Attention To Senator Brown's Hearing On Bank Bailouts

Today the Senate Banking Committee’s Subcommittee on Financial Institutions is holding a hearing on a central question of financial reform – the progress (or lack of it) that has been made on rationalizing the public safety net to ensure that the financial sector doesn’t benefit from inappropriate taxpayer support.

Senator Brown’s hearing deserves wide attention. Considering the trillions of dollars in public support provided by the Federal Reserve to Wall Street and foreign banks over the 2008-2009 period, it’s notable that many Dodd Frank rules designed to limit such support in the future have not gotten much public scrutiny. As the General Accounting Office report to be discussed at the hearing points out, many of these rules have not been completed and their effectiveness remains uncertain. For example, regulators have not even proposed rules for the ‘swaps push out’ provision limiting the public backstop for derivatives dealing at major Wall Street banks, and they have also granted Wall Street a two year extension on any compliance with the law.

Serious questions also remain about whether regulators will be able to limit taxpayer exposure when exercising Dodd-Frank’s proposed new resolution authority for banks of the size and complexity of the largest U.S. ‘too big to fail’ mega-banks. And the Federal Reserve’s proposed implementation of Dodd-Frank limitations on its emergency lending authority – the authority used to distribute those trillions of dollars to global banks during the crisis – would seem to permit a repetition of the kind of indiscriminate public support to Wall Street we saw in response to the financial crisis.

A key lesson of the financial crisis is that the public safety net for the financial system is deeply flawed. Not only did it create inappropriate taxpayer exposure, but the ad hoc bailouts of institutions and individuals responsible for the crisis created dysfunctional incentives for the future.  The GAO report highlights how far we still have to go in addressing this problem within the existing framework of the Dodd Frank Act. Senators Brown and Vitter have also suggested another possible next step in their bipartisan TBTF Act – stronger statutory limitations on regulators’ ability to provide safety net assistance to Wall Street.

The Volcker Rule Is Already Having An Impact

It hasn’t taken long for the final Volcker Rule to send ripples through the financial markets – specifically through markets for asset backed securities. These markets  were famously used to package and sell the subprime ‘toxic assets’ that contributed so much to the financial crisis. Although the mortgage securitization market has shrunk greatly thanks to the disastrous record of mortgage backed securities during the crisis, securitization remains significant in other areas. Industry lobbyists are trying to portray these impacts of the Volcker Rule as somehow unintended or accidental. But in fact the Volcker Rule was intended (and properly so) to affect banks involvement in securitization markets, which were central to the 2008 crisis.

The Volcker Rule’s impact on securitization doesn’t result from the widely publicized provisions on speculative trading. It comes from the part of the rule that forbids bank investments in external funds, like hedge funds. These provisions are at least as important as the more widely discussed restrictions on speculative proprietary trading. Restrictions on external investments are necessary to make speculative trading controls work. If investments in external funds aren’t controlled, banks can just do their speculation at one remove, in ways that are more difficult for regulators and counterparties to understand. And there’s no question about the relevance of these restrictions to the financial crisis. Opaque and non-transparent connections between major banks and external entities like hedge funds and securitization vehicles were central to the problems at major banks during the 2008 financial crisis.

The Volcker Rule’s definition of an external fund includes the ‘special purpose vehicles’ used to organize securitizations. (The vehicles are essentially trusts that hold the loans or other assets backing a securitization). That means that without specific exemptions granted by the regulators, banks won’t be able to own asset backed securities or play a central role in securitizations. In the final rule they just passed, regulators granted such a special exemption. But the exemption is only intended to accommodate ‘plain vanilla’, relatively simple securitizations where special purpose vehicles hold only loans and a limited range of derivatives.  These kinds of securities can still be quite risky, and there’s an argument that regulators already went too far in their exemption. But the exemption would still rule out many of the more complex securitizations that were important triggers of the financial crisis.

The first wave of public industry opposition to the final rule is coming from banks who own such complex securitizations. This week, a wave of lobbyists hit the Hill to decry the Volcker Rule’s impact on banks who own ‘Trust Preferred CDOs’ (a securitization called a Collateralized Debt Obligation, or CDO, that holds Trust Preferred Securities, or TRUPS).

The history of the Trust Preferred CDO market offers a tour of the worst aspects of the pre-crisis financial system. Trust Preferred Securities took off when banks tried to circumvent limits on borrowing by issuing a kind of debt dressed up to look like loss-absorbing capital – essentially promising creditors reliable payments while telling regulators that payments to creditors could be cut off if the bank ran into trouble. Since, unsurprisingly, it was difficult to find investors willing to take this deal, banks trying to sell TRUPS asked Wall Street investment banks to design CDOs that bundled the securities into a product that could be sold as less risky than the basic security. The investment banks in turn pressured the credit rating agencies to certify their risky new CDOs as investment grade by using misleading performance assumptions. To make matters worse, many of these CDOs were purchased by other banks, doubling down on the already high risks of the instrument. (All the gory details are available in this paper).

Thanks to Senator Collins and then-FDIC chair Sheila Bair, strong controls were placed on new TRUPS issuance in the Dodd Frank Act. But about 200 banks – some 3 percent of all U.S. banks — still hold old TRUPS CDOs, which have suffered huge price declines. In many cases their regulators have none the less permitted them to hold these CDOs at historical prices rather than marking down losses based on current market prices. Since the Volcker Rule will force the sale of these assets by 2015, banks that bought them in the past may now have to sell and suffer losses. That’s unfortunate in the case of community banks, since smaller banks who purchased such CDOs were in some ways victims of the Wall Street securitization complex. And it may be possible to work out a way of grandfathering these legacy assets. But it’s crucial that neither regulators nor Congress undermine the Volcker Rule controls on securitization just to ease this transition period.

A second wave of opposition to the new Volcker Rule controls is coming from participants in markets for Collateralized Loan Obligations (CLOs). CLOs generally hold ‘leveraged loans’ made to corporations who do not have strong enough credit to directly issue bonds. (Many of these leveraged loans are used to fund private equity takeovers).  The CLO market is now considered one of the riskier securitization markets around, as leveraged loan practices have been targeted for numerous regulatory warnings over the past few years. Once again, it seems like controls on this market might not be a bad idea. While CLOs that hold only loans can qualify for the existing Volcker Rule exemption, it turns out that many CLOs hold a range of other non-loan securities and thus won’t be permissible holdings under Volcker.

Last night, regulators issued a guidance reiterating the terms of their securitization exemption, and pointing out that financial engineers might be able to find ways to make complex securitization products fit within the terms of that exemption.  While that’s not totally reassuring, it still indicates that the regulators are willing to hold to the limits they just created on bank involvement with potentially toxic securitizations. That’s the right approach. Those limits aren’t an accident – they’re one of the central new protections created by the Volcker Rule.

Why Is 1.5 Million Tons of Aluminum Sitting in Warehouses Owned by Goldman Sachs?

Americans have learned a lot in recent years about how our largest financial institutions make their money. But few would have imagined that a million and a half tons of aluminum – a quarter of the national supply at any given moment – typically sits in a network of 27 Detroit warehouses owned by Goldman Sachs. And hardly anyone would have thought that manufacturers seeking to purchase that aluminum might wait 18 months or more for delivery, while warehouse owners like Goldman Sachs collect additional rent, paid for by consumers of aluminum products ranging from beer cans to home siding.

In an important hearing yesterday before the Senate Banking Committee, Tim Weiner of MillerCoors described the operation and how it boosts prices for real-economy companies. The witnesses at yesterday’s hearing explained how the largest Wall Street banks have accumulated massive amounts of physical commodity infrastructure, ranging from warehouses to oil tankers to power generation plants.

Supply bottlenecks in bank-owned warehouses are only one part of the story. Banks are central players in the financialization of commodity markets, the treatment of physical commodities as purely financial assets to be manipulated for trading and investment purposes, rather than inputs for the real economy.

The original purpose of markets in commodities and commodity derivatives was to ensure steady prices and consistent availability for real-economy users of commodities. But the selling of commodities as an inflation hedge and a retirement asset (over $440 billion in investor money has poured into commodity investment funds since 2004, as opposed to just $25 billion into equity funds) has transformed these markets, increasing price levels and price volatility, and opening up many opportunities for manipulation.

Some of the richest opportunities for such manipulation lie in combining control of physical commodities with dominance of commodity derivatives and futures markets. The major banks are, of course, key dealers in these derivatives markets. Control of physical commodities allows them to both forecast and influence the spot commodity prices that can determine derivatives pricing. Indeed, some observers have pointed out that bank involvement in warehousing has allowed them to conceal information from the markets on the true supply of physical commodities, creating market squeezes and artificially fueling investor appetite for commodity futures.

Big financial players are constantly seeking new ways to take advantage of this nexus. For example, the Securities and Exchange Commission recently approved the applications of JP Morgan and BlackRock for exchange traded funds (ETFs) that will be backed by physical copper. These funds will store physical copper in bank-owned warehouses to back investor shares in the ETF – potentially creating an investor-funded squeeze in the physical copper markets that would raise commodity prices and make market manipulation easier.

The potential conflicts of interest and opportunities for manipulation created by the combination of a dominant position in derivatives markets and a dominant position in actual commodity infrastructure are one reason why the traditional division between banking and commerce makes sense. Banks have a central role in the economy, thanks to their key position in the financial markets, their enormous balance sheet resources supported by leverage levels available to no other industry and their privileged access to liquidity. Unless the scope of their activities is restricted, they have too many opportunities for abuse of market power. As law professor Saule Omarova testified yesterday, Americans have traditionally viewed “large aggregations of financial power in the hands of a few money trusts with great suspicion.” Such aggregation of power is the inevitable result of a failure to separate banking and commerce.

Regulators and legislators can and should take action to limit bank involvement in physical commodities:

  • With increased public scrutiny of the issue, the Federal Reserve announced last Friday that it will review and reconsider its 2003 decision on the scope of commodity activities that it defines as “complementary” to banking and therefore permissible for banks. Reconsideration should lead the Fed to place stricter limits on bank commodity activities.
  • Both regulators and Congress need to reexamine the interpretation and impact of the “grandfathering” provision in the 1999 Gramm-Leach-Bliley Act. Goldman Sachs and Morgan Stanley, who only converted to financial holding companies in 2008, will likely try to rely on this provision to argue that they should be allowed to continue commodity activities.

Regulators and Congress also need to establish clear responsibilities for preventing manipulation of physical commodity markets. Right now, it’s not clear who has this job. The prudential banking regulators do not see the integrity of commodity markets as part of their mandate, even though the institutions they regulate have enormous capacity to manipulate these markets. The Commodity Futures Trading Commission regulates commodity derivatives markets, but not the markets for physical commodities. The Federal Energy Regulatory Commission does regulate spot markets in energy, but not in other physical commodities. The Securities and Exchange Commission regulates securities markets but not commodity markets. And the Justice Department has generalized anti-trust authority to prevent abuse of market power, but lacks the depth of experience and resources to provide a consistent presence policing commodity markets. It’s crucial to get a cop on this beat.

— Marcus Stanley

Originally published on USNewscom.

Pulling Back the Derivatives Curtain

The lack of transparency in financial markets was a significant contributor to the 2008 financial crisis. The risks of toxic securities were hidden behind layers of complexity, and the credit rating agencies tasked with making the bottom line transparent to buyers had crippling conflicts of interests.

On the institutional level, the tangled balance sheets of the critical dealer banks were a major contributor to the market freeze that occurred in late 2008. Uncertainties regarding opaque over-the-counter derivatives, complex interbank relationships and “toxic asset” exposures were such that counterparties simply refused to deal with major banks at the center of the system, and the markets froze. Regulators also clearly lacked understanding of bank risk exposures both during the crisis and in the years leading up to the crisis when intervention could have been effective

At the heart of the transparency problem was and is the complexity of the shadow banking system, in which credit is intermediated through extensive securities market relationships. The balance sheets of traditional banks could be understood by examining the underwriting of their loans and their relatively limited set of funding sources. But modern universal banks have a tangled web of securities exposures involving enormously complicated derivatives commitments, short-term funding collateral and elaborately structured securities.

The shadow banking problem is far from solved. But recent financial reforms contain numerous elements that could improve the availability of critical data. However, it’s still far from clear that all of these initiatives will be properly implemented.

What’s more, the ability to integrate and interpret this flood of new data is still lacking. It’s an open question whether all this raw data will result real knowledge that will help both regulators, market participants and the public understand the financial system more effectively.

Here are some of these initiatives:

Derivatives market transparency: For market participants, trading facilities will now offer real-time data feeds for the trading of standardized swaps. Transparency to market participants is still lacking for so-called over-the-counter swaps. For regulators, new swaps data repositories should massively increase the information available to regulators on all swaps.

Transparency of banks: The newly approved international Basel rules contain a list of new bank disclosures that are meant to update the traditional “call report” and 10-K to give more information on the activity of dealer banks. Depending on implementation, these disclosures have  the potential to significantly improve information available to market participants. New accounting rules should also reduce the ability of banks to conceal assets off balance sheet.

On the regulatory side, banks are now required to submit “living wills” to regulators detailing how they could be resolved in the event of financial difficulties. These should greatly improve regulators understanding of bank internal structure. However, their current public versions offer little to no transparency to market participants.

New tracking of credit exposures will also improve regulators’ understanding of interrelationships in the banking system, and regulators at the New York Federal Reserve are working to improve information on securities lending markets. Regulatory stress tests have also improved the effective transparency of bank activities to regulators, as these stress tests require tracing out relationships that may not be visible on the balance sheet alone.

Securities market transparency: The Securities and Exchange Commission has issued new rules on disclosure requirements for asset-backed securities. New SEC rules for credit rating agencies are designed to improve the reliability of ratings information and thus the transparency of securities, although the SEC has apparently rejected radical reform and the effectiveness of its proposed rules seems highly doubtful.

In addition, the new common securitization platform being designed by the federal housing agencies could radically increase the availability of loan-level data for mortgage-backed securities, and possibly simplify and standardize the structure of asset-backed securities as well. One of the few areas of consensus in the reform debate is the desirability of improving the standardization of mortgage-backed securities to make them more transparent for investors.

Overall financial system transparency: The new Office of Financial Research has the ability to amass information centrally to map out areas of stress in the financial system, and also has various legal powers to improve information standardization and accessibility in the markets.

But despite the impressive number of initiatives in progress, it is doubtful that the financial markets are much more transparent to even sophisticated users than they were five years ago. Only a small amount of the new data is available to the public as opposed to regulators. And even regulators, with full access, have great difficulty making sense of the data.

The experience of the so-called “London Whale” demonstrates the continuing limits of regulators’ ability to truly understand bank operations. Richard Berner, the director of the Office of Financial Research, recently admitted that regulators were far from a clear understanding of the nature and location of systemic risks. Data gaps continue to exist, and lack of standardization even in the data that is available makes it hard to use analytically.

Much more work must be done to turn data into real understanding. Besides problems with the data itself, too little is available to the public, even in aggregated form. Along with particular initiatives, regulators need to think about how to engage market analysts, academics, and the public in “crowdsourcing” a better interpretation of the financial system.

— Marcus Stanley

Originally published on

The Fed's Forever Bailout

In the Dodd-Frank financial reform law, Congress tried to put some minimal restrictions on the Federal Reserve’s powers to bail out Wall Street – but it doesn’t look like the Fed is interested in cooperating. Three years after the agency was instructed to specify new bailout rules “as soon as practicable,” the Federal Reserve still hasn’t done so.

The moral hazard created by bailouts for irresponsible financial behavior is an issue central to financial reform. During the 2008 crisis, the federal government provided unprecedented amounts of assistance to Wall Street, and provided it on extraordinarily favorable terms. The $750 billion Troubled Asset Relief Program authorized by Congress got the most attention, but TARP was just the tip of the iceberg.

Almost a year before TARP, the Federal Reserve began to use its emergency powers under Section 13(3) of the Federal Reserve Act to provide low-interest loans to Wall Street. Over the two years from 2007 to 2009, some $16 trillion in emergency lending flowed through Federal Reserve facilities. At the peak of the Federal Reserve’s emergency bailout, some $1.5 trillion per day was being loaned to various Wall Street and foreign banks.

The Federal Reserve’s use of its emergency powers went far beyond any historical precedent. Section 13(3) of the Federal Reserve Act, which permits the Federal Reserve to do emergency lending to businesses under “unusual and exigent circumstances,” was passed in 1932 during the depths of the Depression. The context differed profoundly from today – for example, policymakers were concerned that in some regions with extensive bank failures, businesses might lack banking services altogether. The original 13(3) also contemplated that emergency powers could be used to lend directly to businesses, instead of simply to financial interests. But even during the Great Depression, the use made of these emergency powers was strictly limited, with less than $2 million in loans made over four years.

While it’s somewhat accepted for central banks to provide some emergency assistance during times of financial stress, the Federal Reserve’s use of its emergency powers went well beyond normal principles of central banking.  Since the 19th century, those principles have called for lending on a temporary basis and at a “penalty rate” – that is, at an interest rate above the prevailing market rate.

The use of a penalty rate means banks which need assistance would have an incentive to self-cure and would bear part of the costs of their rescue. As researchers have documented, the Federal Reserve blatantly violated these principles, extending massive loan programs for a period of years and providing heavily subsidized assistance at rates far below the market rate.

In a compromise, the Dodd-Frank law permitted the Federal Reserve to retain broad emergency lending powers, but placed new limitations on their use. Under Section 1101 of the law, emergency lending must be secured by good collateral and may only be performed through programs with “broad based eligibility” that are limited to “solvent” companies and are not designed to assist a single failing bank. Lending programs also must be terminated in a “timely” manner.

While the restrictions sound good in theory, the legislative language is far too broad and vague to provide an effective check on the Federal Reserve’s emergency powers. The meaning of a “solvent” institution or “good collateral” is often in the eye of the beholder. And a program with “broad based eligibility” can easily be structured to be especially beneficial to holders of a selected class of assets – for example, a program that allowed financial institutions to convert toxic securities into cash could be seen as “broad based,”  since anyone holding such securities would be eligible.

For that reason, Section 1101 also required the Federal Reserve and Treasury to immediately write regulations setting out the exact policies and procedures governing its emergency lending programs. In fact, the Fed was required to propose these regulations “as soon as is practicable.”

But the Federal Reserve seems to be simply ignoring this requirement. Today, three years after the bill was enacted, regulations still haven’t been proposed. The delay isn’t because good rules would be particularly complicated to write. For example, a restriction on emergency lending to a strictly limited time period – say, 90 days – would automatically tend to restrict assistance to financial entities which are actually solvent and have good collateral. That’s because a solvent institution that faces temporary liquidity problems due to market disruptions should be able to find private sector funding over a relatively short time period, while a truly insolvent institution could not.

Clear and forceful rules to limit future Federal Reserve bailouts are necessary to address the expectations created by recent experience that the government may pick up the tab for irresponsible Wall Street behavior. Unfortunately, the Federal Reserve’s inaction on these rules undermines confidence that it’s serious about obeying the new restrictions. It’s past time for them to put the rules in place. Sens. Sherrod Brown, D-Ohio,  and David Vitter, R-La., have introduced new legislation that – along with significantly increasing capital requirements for big banks – would also place far stronger limitations on Federal Reserve emergency assistance. The longer the Federal Reserve delays, the stronger the case looks for doing so.

  — Marcus Stanley

Originally published on


Wall Street's Derivatives Gambit

This week marks an important step forward in the implementation of financial reform. On Monday, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection in these previously unregulated markets.

But even as this crucial protection takes effect, Wall Street is mobilizing to create a back door escape route. Its goal is to prevent U.S. regulation of derivatives transactions by U.S. companies that are conducted overseas.

This loophole could strike at the foundations of financial reform. Almost every major financial scandal involving derivatives – from the collapse of Long Term Capital Management’s Cayman Island operations in the 1990s, to the bailout of AIG’s London-based trades in 2008, to JP Morgan’s recent “London Whale” trading losses – has involved derivatives transactions conducted through a foreign entity. Wall Street banks routinely transact more than half their derivatives through foreign subsidiaries. Through numerous avenues, including an important Congressional vote today, Wall Street is trying to create an “extraterritorial” loophole in derivatives regulation.

Derivatives are essentially bets on future financial moves. Prior to the crisis, the massive markets in derivatives (over $300 trillion in notional value in the U.S. alone) were essentially unregulated, and conducted as simple contracts between any two financial firms. There was almost no public transparency or regulatory oversight of firms’ derivatives books, and no assurances that firms could deliver on the bets they made. This was a major contributor to the financial collapse.

The Dodd-Frank financial reform law of 2010 brought these markets under regulatory oversight for the first time. Although implementation of the rules has been greatly delayed by heavy industry opposition, we are finally beginning to see some progress. As of Monday, the Commodity Futures Trading Commission requires most U.S. derivatives transactions to be conducted through centralized clearinghouses. Clearinghouses specialize in risk management and guarantee performance of the contract. Future regulatory actions should bring close to 90 percent of the market under mandatory clearing.

Wall Street lobbyists are pushing hard to undermine this progress by exempting foreign transactions. If they succeed, entities nominally based in foreign countries but active in U.S. derivatives markets will not have to comply with U.S. derivatives rules. This could potentially include foreign subsidiaries of U.S. banks, the numerous U.S. hedge funds incorporated in places like the Cayman Islands and subsidiaries of major foreign banks that are major dealers in the U.S. markets. Because derivatives markets are global and conducted electronically, a click on a computer keyboard is all it takes for a major bank to route any transaction through a non-U.S. subsidiary. But the risk can still return to impact the U.S. economy.

Industry opponents claim that the rules of foreign countries will protect us in these cases. But no country in the world is as advanced as the U.S. in regulating its derivatives markets. While the U.S. is actively bringing derivatives regulations on line, key elements of oversight are still at least a year away in Europe and elsewhere. And permitting foreign regulation to govern U.S. derivatives transactions would be dangerous in any case. It would create an incentive for global banks to transact their business through whatever jurisdiction has the weakest regulations – a “regulatory haven” to match the tax havens that international corporations already use.

Multiple efforts are underway to undermine international derivatives rules. In Congress, the House will vote today on HR 1256, a bill that would sharply limit the jurisdiction of U.S. derivatives regulators over transactions conducted in foreign markets. This bill is likely to pass the House, having gained the support of a large majority of the Financial Services Committee – but it’s still important for pro-reform forces to register opposition. There should be more resistance in the Senate, where six Senators led by Sen. Sherrod Brown, D-Ohio, recently sent a strong letter to regulators supporting effective international regulation of derivatives markets.

At the same time, both Wall Street and foreign regulators are pressing the Commodity Futures Trading Commission to step back from enforcing its rules overseas. The CFTC is scheduled to begin enforcement next month, on July 12, but industry is pushing for additional and perhaps indefinite further delays. While current CFTC chairman Gary Gensler is a strong supporter of effective regulation, other commissioners, led by Scott O’Malia, favor more delay.

Finally, industry and (astoundingly) some members of Congress are seeking to renegotiate U.S. financial regulations through secretive international trade negotiations, which could allow numerous new international exemptions to be added without any public accountability or oversight.

It’s crucial that these efforts do not succeed. After years of work to implement basic safeguards in the massive shadow markets that crashed the global economy, we can’t let Wall Street sidestep these protections simply by taking its business overseas.

— Marcus Stanley

Originally published on

Is the SEC Disproving The Laws of Supply and Demand?

A new staff memorandum from the SEC appears aimed at disproving the law of supply and demand.

The issue is whether to permit JP Morgan Chase and Blackrock to create new exchange traded funds (ETFs) backed by physical copper. The new ETFs will track a commodity price, the price of copper, as many ETFs already do. But instead of using futures or derivatives to replicate copper exposures, the ETF can stockpile physical copper to back up its shares. So these ETFs will control large stores of physical copper for the benefit of ETF owners. JP Morgan’s prospectus states that initial offering of their ETF will result in the purchase of as much as 30 percent of the copper currently available for immediate delivery worldwide.

There are already ETFs backed with physical metals, but only for basically financial assets like gold or silver. Copper is a crucial industrial metal, and this would be the first time a fund had been allowed to stockpile such a vital commodity. It’s well known that speculation in key commodity markets using swaps and other derivatives has increased massively in recent years, and there’s plenty of evidence that such speculation can greatly affect prices. But at least in the case of such paper speculation there is still one layer of remove between market positions and physically hoarded positions. That’s not true here. Every time an investor purchased a share of this ETF, they would in effect be contributing to a market squeeze by hoarding actual physical copper.

If you think that sounds like a bad idea, well the actual copper industry strongly agrees with you.  Their comment on the proposal states these ETFs would “grossly and artificially inflate prices for an industrial commodity already in short supply”. Opposition to the proposal was also registered by Senator Carl Levin and Americans for Financial Reform.

Now the SEC staff has examined the issue, and come up with surprising finding that there is no apparent relationship between copper prices and available copper supplies. This is a finding that would revolutionize financial markets — if they believe their findings the authors could leave government employ and make large amounts of money trading against investors who still assumed that the availability of a commodity affected the price. Indeed, the finding disagrees even with the filings by JP Morgan and Blackrock themselves, which freely admit that the new investment vehicles may impact real economy copper prices. See for example this comment on page 10 of the Blackrock iShares ETF prospectus:

An increase in the demand for copper, driven by the success of the trust or of similar investment vehicles, could result in increases in the price of copper that are otherwise unrelated to other factors affecting the global copper markets.

Because there is no limit to the number of Shares that the trust can issue, a very enthusiastic reception of the Shares by the market, or the proliferation of similar investment vehicles that issue shares backed by physical copper, could result in purchases of copper for deposit into the trust or such similar investment vehicles that are large enough to result in an increase in the price of physical copper.

The methodology of the SEC staff memo is deeply flawed.  Among other things, the authors ignore evidence in their own analysis that hoarding supplies does in fact influence prices, fail to deal with basic methodological issues involving the inference from correlation to causation, and ignore key facts about the actual structure and functioning of copper markets. (If you want further detail, here is AFR’s detailed analysis of the problems with the staff memorandum).

The numerous problems with this memo illustrate how far we still have to go in convincing the SEC that commodity-related ETFs can distort commodity supplies and encouraging excessive speculation.  But the SEC can still rescue the situation by recognizing the flaws in the staff analysis, giving it the weight it deserves – none at all – and rejecting the application to trade physically backed ETFs in key commodities. This decision is critically important, not only for the copper markets, but also because the approval of these ETFs would set a precedent for the further financialization of the broader commodity markets. It would also, for the first time, essentially give legal permission for the hoarding of physical supplies by persons who may also be trading in the commodity itself. If a physically backed ETF is approved for copper, there is nothing to prevent it happening for oil and food as well. Turning down physically-based ETFs should not be a hard call for the SEC, but it’s not clear if they will do the right thing.

SEC Will Hear Public Comment Before It OKs Advertising of Private Offerings

Rarely does a protest bear such quick fruit. Last Wednesday (Aug. 15), a group of former securities regulators, securities law experts, and advocates for investors, workers, and older Americans, including Americans for Financial Reform, appealed to SEC Chairman Mary Schapiro to reconsider a reported plan to skip the traditional comment-and-review process for a new rule under the controversial JOBS Act. The rule in question would lift a long-standing ban on the general solicitation and advertising of private stock offerings.

The following day, the SEC announced that it would, after all, seek prior public input. Chairman Schapiro, according to a spokesperson for the agency, “believes it is important for the general solicitation rule to be proposed for public comment, as is our typical practice in rulemaking.”

The clarification drew approving responses from those who had earlier expressed alarm. “We applaud Chairman Schapiro and the SEC Commissioners for their willingness to listen and respond to investors’ concerns,” CFA Director of Investor Protection Barbara Roper said in a Friday statement. “Ultimately, the final rules adopted will be the test of the Commission’s commitment to protecting investors and market integrity. But slowing down the process and allowing an opportunity for careful analysis and public comment is the first essential step toward producing a strong, pro-investor rule.”

The pushback from those who had wanted a rule issued right away (without public input, without weighing the impact on investors and the capital markets – in short, with the legal requirements for notice and comment be dammed – was not long in coming.  Rep. Patrick McHenry (R-NC) promptly accused Schapiro of being motivated by “ideological opposition to a bipartisan effort by Congress and the President to improve the conditions for capital formation in the United States.”

Rep. McHenry was a leading House champion of the JOBS Act, which set a 90-day deadline for lifting the advertising ban. But, as critics noted, the statute also directed the SEC to observe established investor-protection standards in the course of implementing that change. The deadline “did not provide a realistic timeframe for the drafting of a new rule, the preparation of an accompanying economic analysis, the proper review by the Commission, and an opportunity for public input,” the SEC spokesperson said on Monday.

The congressman’s outcry is particularly ironic given that, when it comes to Dodd Frank rules to hold Wall Street accountable and protect the public interest, Rep. McHenry has pushed in exactly the opposite direction. (See

Chesapeake Energy And Derivatives Reforms

Chesapeake Energy has been a leader in the ‘end user’ lobby to weaken derivatives reforms. But the recent problems at that company – which some in the business press are likening to a new Enron – help show why these rules need to be kept strong.

As in the Volcker Rule, new derivatives rules try to distinguish hedging from speculative activity. Hedging transactions, especially by non-financial ‘end user’ companies like energy producers, are exempted from most new derivatives requirements, including critical clearing requirements. Commercial companies that can classify their transactions as ‘hedges’ can also be exempted from special oversight as major players in the swaps markets, and hedging transactions are also exempted from position limits designed to lower speculation in commodity markets.

That means a key priority in crafting effective derivatives rules is ensuring that the hedging exemption is kept narrow and is restricted to only genuine hedge transactions. But ‘end user’ companies have been arguing for as broad a hedging exemption as possible. Chesapeake Energy was in the forefront of ‘end user’ companies arguing for hedging exemptions to be expanded. Here they are telling the Commodity Futures Trading Commission that they should be exempt from various derivatives rules because they never speculate (emphasis in original):

“we are strictly prohibited from hedging more than our estimated underlying production for any given future month, meaning we can not and do not speculate.”

That’s an argument they also made to ask for exemptions from speculative position limits. But it turns out that that at least their CEO certainly does speculate. Chesapeake CEO Aubrey McClendon has been running his own energy hedge fund out of the same address as the company headquarters, using the company’s own staff. This is not ideal, especially when it’s easy to create another business that can invest freely. Plus, the CEO didn’t even need to use this business address when he could be using a registered office provider for a company. There are many ways to work with the system but it seems the CEO has gone about this move in the wrong way.

The company’s financials – which show that over one quarter of their total revenues since 2006 have come from ‘hedging’ profits – have led Fortune Magazine to state that “they look more like a Wall Street hedge fund” than an energy firm. And the Wall Street Journal has now documented that Chesapeake regularly made short-term speculative plays in the energy markets. In an unfortunate irony, the company’s speculative ‘hedging’ strategy seem to have misfired so badly that Chesapeake was forced to go unhedged in the energy markets this year, taking on exactly the risks that hedging is designed to prevent. Clearly, regulators need to look carefully at end user claims that they ‘do not speculate’.

Here is Chesapeake Energy again arguing to regulators that they should be exempted from new rules requiring companies to put up real money as collateral to back their derivatives bets. Instead, they argue that they should be allowed to put up mortgages on unproven oil and natural gas fields as derivatives collateral. This would tie their derivatives bets on future energy costs directly to the other great risk the company faces, namely whether the energy fields they have purchased will pay off. The value of those fields is yet another issue being questioned by the press.

Chesapeake is apparently overextended along many dimensions and derivatives are just one aspect of this. But the new derivatives rules under Dodd-Frank would help ensure that at least derivatives risk management is done properly and transparently at energy companies. Energy companies need to be upfront with their customers on all levels no matter the services, from fixed energy rates to prepaid lights services. That can help protect the company’s stockholders and the broader financial market from the fallout from reckless speculation. And the Chesapeake example definitely shows that regulators shouldn’t buy the argument that end user companies never speculate.