I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.
Here are some random thoughts.
First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate. Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities. It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.
Second, the fading of the Lincoln provision is quite artfully done. I had to read the damn thing several times to figure out just how they did it. The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions. Pretty big exception. So where did the exclusion of commodities and equity swaps come from? Well, the bill permits:
Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”
And what does this “Seventh” paragraph say? It says that banks are allowed to:
Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.
So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and bullion (presumably precious metals) are all OK. The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out. Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off. (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)
Third, the bill does an amazing amount of punting on key issues. The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers. Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.) If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.
Fourth, two things relating to margins jumped out at me.
The bill states:
MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]
But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization. But periods of systemic instability are, by definition, highly abnormal. So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves? This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral. Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver. It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.
The other thing relates to margins on non-cleared derivatives. The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:
Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.
Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements. Prudential regulators will set margins that will:
be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.
This is potentially quite dangerous. It is a form of price control, and such controls will have perverse effects (as they always do).
In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels. Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments. This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.
Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced. They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.
We’ve seen this before. The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences. Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks. As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants. This is another example of that. Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.