I transfered from the Naval Academy to the University of Chicago as a junior. I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball. No such thing in Annapolis, let me assure you. How lascivious? Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves. (Maybe they were lettuce leaves. I wasn’t checking that closely.)
What brought that to mind, you ask? A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.
Why? Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.
Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window). The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities). The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.
Here are the market values, by category (gross positive values followed by gross negative values):
$ in billions
Q1 2010 Q4 2009 Change %Change Q1 2010 Q4 2009 Change %Change
Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%
FX 347 354 (7) -2% 345 344 1 0%
Equity 77 91 (14) -15% 78 90 (12) -13%
Commodity 41 50 (9) -18% 40 49 (8) -17%
Credit 390 437 (47) -11% 370 409 (39) -10%
Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%
So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total. (Gross negative values give a similar share.) Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off. This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.
Here are the notionals:
Interest Rate Contracts 181,981 179,555 2,426 1% 84%
Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%
Equity Contracts 1,571 1,685 (114) -7% 1%
Commodity/Other 940 979 (39) -4% 0%
Credit Derivatives 14,364 14,036 329 2% 7%
Total 216,452 212,808 3,645 2% 100%
Commodities are rounding error. Equity and commodities is about 1 percent of notional. Even adding in all of credit, and you don’t get to 10 percent.
It would be nice to have a risk breakdown, but that’s not in the OCC data.
Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.
It’s not a big deal to the banks, but it is a pretty big deal to the commodities business. Spinning off commodities will make it more expensive for dealers to make markets. Some may decide it’s not worth the bother. So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.
This is just one of several hits to the commodity business in the bill. Indeed, commodities are arguably the biggest loser.
The bill says the CFTC “shall” impose position limits on OTC commodities. This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity. Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC. The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.
Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users. The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.
In sum: the compromise bill shafts commodities not once, not twice, but three times. This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.
And for what? The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake. The niggardly end user exemptions will not affect systemic risk either. The position limits will not reduce price distortions in the market.
Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost. All to give a politically desperate senator a fig leaf.