Streetwise Professor

June 29, 2010

Selected Observations on Frank-N-Dodd

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 8:03 pm

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.

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  1. […] This post was mentioned on Twitter by Craig pirrong, Craig pirrong and others. Craig pirrong said: Updated my SWP blog post: ( ) […]

    Pingback by Tweets that mention Streetwise Professor » Selected Observations on Frank-N-Dodd -- — June 29, 2010 @ 8:11 pm

  2. The basic problem they are trying to solve is this: some things pitched as investments turn out after the fact to have really been gambles.

    The Dutch Parliament had a solution to this problem in 1630- treat those contracts which now looked gambles as gambles and so deny the parties the right to Courts to resolve the liabilities.

    Parties then settled for 10-15 cents on the dollar by themselves – and these settlement agreements were enforceable.

    If participants in the derivatives markets were afraid that their clever schemes might be seen as promoting illegal and unenforceable gambling debts, I am fairly confident that we could count on market forces to tamp down some of the more idiotic schemes.

    Comment by michael webster — June 29, 2010 @ 9:34 pm

  3. Michael–sounds like you’ve been reading Lynn Stout.

    The ProfessorComment by The Professor — June 29, 2010 @ 9:53 pm

  4. The Professor – I haven’t read Lynn Stout, but on your implied recommendation I am now reading her paper on “The Investor Confidence Game”. Anything else you think I should look at?

    Comment by michael webster — June 30, 2010 @ 4:51 am

  5. MW–She has an article in Regulation magazine from last year that makes the exact same argument that you do: namely, derivatives contracts should be treated as uneforceable wagers. I have a rather critical (understatement alert) reply in the same issue.

    The ProfessorComment by The Professor — June 30, 2010 @ 7:32 am

  6. I still submit that we can’t reform the finacial system without first reforming the regulators.

    Comment by Charles — June 30, 2010 @ 11:06 am

  7. Charles–agreed. But I think we should start with something easier. Like time travel.

    The ProfessorComment by The Professor — June 30, 2010 @ 12:59 pm

  8. @ The Professor;

    I don’t get the magazine, but I would not support the idea of making all derivative contracts as unenforceable wagers. Many derivative contracts do exactly what the Arrow/Debreu theorem says they should.

    My point was that if upon an investigation by the DOJ, the contract was more akin to gambling than real allocation of risk, then the contract should be in danger of being treated as a non contractual matter.

    @ Charles, the regulators don’t need reforming. Their job is simply to console the losers.

    Comment by michael webster — June 30, 2010 @ 5:41 pm

  9. Michael–Regulation mag is available online. Go to then click on the publications . . . and go from there.

    The problem is that ex post, somebody (the losing party) always has an incentive to claim that the deal was a gamble. There was a lot of litigation in the late-19th early-20th centuries along these lines. Courts finally gave up trying to parse the motives of traders, and said the deals were enforceable.

    If you can track it down (I think it is available on Google books) the FTC’s Report on the Grain Trade (Vol. V–Futures Trading Methods in Grain, if memory serves) has some very good descriptions of some of these old cases.

    The ProfessorComment by The Professor — June 30, 2010 @ 9:15 pm

  10. @The Professor;

    1. Yes, of course after the fact everyone will yell foul, whether or not a foul has been committed. This is true in all commercial litigation.

    2. No, motives don’t count. Whether something was a gamble or not does not depend upon the subjective intentions held by the parties.

    3. Thanks for the reference to the Regulation online article. Stout’s argument that for a derivatives contract to be valid, one party has to have an insurable interest in the underlying property is just not reasonable. Speculation, naked short selling, and misdirection all of their place in any sophisticated market.

    4. In the tulip bubble, what you had were tulip futures being sold to individual who purchased them with promissory notes, notes that had no security or collateral but the futures. There was no requirement of a down payment, although 5% was usual in the beginning. Tulip futures were sold by people who had no tulip holdings to people who had no money in a bar using the Dutch Auction method, and payments were made by promissory notes. The no margin requirements, the lack of tulip ownership, the lack of legitimate transfer of risk, and other factors could will lead a Judge to decide that the process was one of gambling and not investment. I don’t know that it would, but the very possibility that it might should have poured cold water on excessive speculation.

    5. Vernon Smith has done a number of experiments on bubbles. So my claim should admit to an experimental proof/disproof. Set up the bubble generating trades, but tell people that after the fact a Gambling Commission might come in and review their trade, find it to be a gamble and disqualify it. See if those instruction tamp down the bubble.

    Comment by michael webster — June 30, 2010 @ 11:20 pm

  11. SWP – great post as always. one small note – the punt returner for the Bears is Devin Hester, not Darren. Enjoyed your talk at ISDA a few months back. Keep up the good fight.

    Comment by oldblueprop — July 2, 2010 @ 7:21 am

  12. oldblueprop–Thanks re both post and ISDA. I’ll keep swinging. My bad re Hester . . . nice catch. I guess I shouldn’t return punts myself 🙂

    Michael–nice comment. Re experiment: good ideal. It is interesting to note that in many of the bubble experiments, the existence of a futures market that permits short selling reduces the frequency and severity of bubbles.

    The ProfessorComment by The Professor — July 2, 2010 @ 9:58 am

  13. […] around and this is broadly in agreement with others’ thinking (e.g., Craig Pirrong in a 2010 Streetwise Professor post). The CDS push-out provisions are quite black and white, but the other push-out candidates […]

    Pingback by Some More Specifics of the Dodd-Frank Act Swap Push-Out Rule « The Kiffmeister Chronicles — December 13, 2014 @ 1:48 pm

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