Streetwise Professor

May 26, 2010

You’ve Caught the Car, Gary. Now What Are You Going to do With It?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 7:08 pm

Whatever emerges from the House-Senate financial regulation conference committee, the CFTC’s power and responsibilities will be greatly expanded.  Most notably, the agency will have vast power and discretion over the OTC derivatives markets.  It apparently will have considerable say in determining what contracts must be cleared and what firms must subject their trades for clearing.  Moreover, it will have responsibility to oversee the operations of central counterparties, which will have important implications for the stability of the financial system; misteps here could induce a serious systemic problem.

Just a few years ago, the chairman of the CFTC, Walt Lukken was bemoaning the agency’s lack of funding, claiming that it had insufficient resources to carry out its (then far narrower) duties.  The agency’s funding has increased, and its head count has increased about 20 percent.  It is slated to increase further to permit it to carry out its new charges.

But, as I’ve pointed out before, the CFTC was never renowned as an extremely effective regulator.  Indeed, it was often something of a Congressional whipping boy because of its perceived shortcomings.  (Example: I remember well the agency’s humiliation when then-Chair Wendy Gramm was forced to stand silent in the background while the Justice Department and the FBI announced indictments against Chicago floor traders for assorted misdeeds.  The clear implication was that the CFTC was not capable of policing the markets.)

Whether that reputation is deserved or not, there is considerable room for skepticism about the CFTC’s ability to handle its new duties.  Any dramatic expansion of an organization into new areas inevitably leads to growing pains and managerial snafus.  That goes double for a dramatic increase in the size and scope of a government organization.  And the stakes are extremely high now, given the systemic importance of clearing.  Requiring the clearing of unsuitable instruments, for instance, could jeopardize the stability of clearinghouses–and hence the financial system.  So could lapses in monitoring the operational or risk management activities of CCPs.

And it must be remembered that the agency will have to handle these new tasks in a hypercharged political environment, one more intense than it has to cope with now.  The stakes will be higher, with big players having a far bigger amount of money affected by CFTC decisions.  With greater stakes will go greater pressure, most notably from Congress, which will respond to constituent pressure.  Can the agency handle it?  Color me skeptical.

Some Commissioners are now openly expressing concerns about the agency’s ability to shoulder the load:

US financial reform regulation could place “overwhelming” burdens on the Commodity Futures Trading Commission, the regulator that would have to assume a new role as watchdog for the swaps markets, officials there said.

Sweeping financial legislation approved by the Senate last week dramatically elevates the role of the CFTC, created in 1974 to police trading in futures and options. The commission would gain broad new powers to oversee previously unregulated over-the-counter derivatives, a universe 10 times larger than regulated markets.

“It’s overwhelming. It’s not like right now we don’t have enough on our plate,” said Jill Sommers, one of two Republicans on the five-member commission.

Senior officials warn that to perform its new role, the CFTC, which has long operated in the shadow of the better-funded Securities and Exchange Commission, will strain its expertise, organisational structure and technology. It would have to propose, take public comment on and then adopt as many as 50 elaborate rules in six months, a timetable that Michael Dunn, a Democratic member of the commission, called “pretty much an impossibility”.

. . . .

Gary Gensler, the CFTC chairman, was among the Obama administration’s staunchest champions of legislative language that would route most derivative trades to clearing houses. This would allow regulators to peer at the size of traders’ positions and, so it is hoped, head off the kinds of risky positions that led to the $180bn (£124bn, €143bn) AIG bail-out. While sharing oversight with the SEC, the CFTC would regulate the majority of derivative deals.

. . . .

CFTC officials acknowledge being snowed under. Probes into oil and silver markets announced in 2008 remain unresolved. Mr Gensler has said the agency was overwhelmed by Ponzi scheme cases. Last week Scott O’Malia, a Republican commissioner, said the agency still gets account information by fax and enters it manually. “This agency is about to be hit with a tsunami of trade data,” he said.

Remember, regulation can create systemic risks.  One way to do that is to place extraordinary burdens on a regulator unprepared to handle it.  Which is what Congress is in the process of doing.

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  1. Does this mean that auditors once again stand to make a lot of money? Just like Sarbanes-Oxley aftermath?

    Comment by Surya — May 26, 2010 @ 10:38 pm

  2. Not just the auditors. The lawyers. I spoke at a conference in DC yesterday. Most of the audience were lawyers. I can’t tell you how many of them find the impending changes objectionable on principled grounds, but believe it will be very, very, very good for business. When the lawyers and auditors prosper, look out.

    The ProfessorComment by The Professor — May 26, 2010 @ 11:03 pm

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