Not Just Technical — The War on Derivatives Reform

Unregulated derivatives markets have been at the center of almost every major financial crisis of the past two decades, from the 1998 bailout of Long Term Capital Management to Enron to the catastrophic financial collapse of 2008. (A fuller list would include the implosion of Banker’s Trust and Barings Bank, the bankruptcies of Orange County and Jefferson County, and numerous more ‘minor’ scandals). Derivatives can allow almost unlimited exposure to speculative risks, and no financial regulatory regime can be secure as long as they remain unregulated.

But derivatives regulation is highly vulnerable to attack by industry lobbyists. The technical details can be complex, and are understood by few outside the industry. So it’s easy to disguise major loopholes as ‘technical amendments’ or ‘clarifications’, even if the changes would seriously weaken or even destroy the capacity to regulate derivatives. Adding to the problem, the agencies responsible for derivatives reforms – the tiny Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) — are comparatively small and, unlike the banking regulators, depend on Congress for funding.

Industry lobbyists are trying to capitalize on this vulnerability through a coordinated assault on derivatives reform. One element of this attack is the so far successful effort to deny adequate funding to the CFTC, a key derivatives regulator. Another is a set of bills currently working their way through the House.

This legislation is usually presented as minor technical or clarifying changes, but that’s far from the truth. For example, the “Swaps Jurisdiction Certainty Act” (HR 3283) would make a huge range of derivatives reforms almost impossible to enforce by allowing big banks to evade derivatives regulations any time they deal through their foreign subsidiaries. Major banks have hundreds and sometimes thousands of foreign subsidiaries, and currently do more than half of their derivatives business through foreign affiliates. So such evasion would not be difficult. HR 2586, also being presented as a minor clarification, would make it almost impossible to achieve a significant goal of derivatives reform — ensuring fair price competition and full customer transparency in derivatives dealing. Under HR 2586 regulators would be banned from enforcing basic price transparency requirements at new derivatives exchanges. These bills have passed the House Financial Services Committee with some bipartisan support.

Another bill, HR 3336, has already passed the house by a 312-111 vote. Sold as a technical amendment that would assist small business, it would in fact eliminate key oversight rules for banks doing up to $200 billion in interest rate derivatives, global oil companies who do swaps trading, and other big financial players. Two other bills – HR 2779 and HR 2682 – are somewhat less sweeping but still have the potential to create real weaknesses in derivatives oversight. That’s particularly true in the case of HR 2779, which bans any regulation of swaps between affiliated companies.  This legislation has already passed the House with large majorities.

It’s striking that a number of these bills include such sweeping language that as originally drafted  they would have made it difficult to enforce not just new reforms but even pre-2008 prudential regulations on bank activities. This made someone nervous enough that sponsors added ‘reservations of authority’ language stating that key banking regulators such as the Federal Reserve would not be bound by the legislation when enforcing longstanding banking laws. It’s possible that this made some regulators less worried. But of course it leaves in place the damage to new derivatives reforms. If pre-crisis regulation had been sufficient we wouldn’t have needed reform at all.

Opponents of reform hope to pass off these major loopholes as unimportant technical amendments and potentially win large bipartisan majorities in the House. Although House bills passed on a partisan basis receive little attention, the hope is that a bipartisan majority would force attention to these bills in the Senate. But even amended versions of some of these measures would represent a significant setback. Consideration of these bills is also intended to intimidate the regulators as they work to complete derivatives rules. The experts at the regulatory agencies are supposed to work in a non-political environment, but they are now under fierce pressure from industry lobbyists. We’ve already seen cases where industry lobbying severely weakened regulations between the initial proposal and the final rule. A show of force in Congress increases the political pressure.

Fortunately, this is a battle we can win. All that’s necessary to stop this assault in its tracks is for Congressional supporters of reform – as well as the Administration — to hold firm and speak out in support of the common-sense derivatives oversight regime passed in law, and give regulators time to implement it. A bill that passes by a relatively narrow or partisan majority in the House is likely to die unnoticed in the Senate. It’s disturbing to see legislators of both parties, even some who in the past have supported reform, signing on to some of these bills or indicating their willingness to support them with amendments that could leave dangerous provisions still in place. We need legislators to stand up for the public interest, defend the derivatives reforms in Dodd Frank, and to let regulators do their job of implementing them. Join AFR’s mailing list or contact us at to learn how you can help.