Journalism in the Public Interest

Dodd-Frank’s Derivatives Reforms: Clear as Mud

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When the architects of the Dodd-Frank regulatory overhaul flinched from the most effective solution — breaking up the banks so that none would be too big to drag down the financial system — they forced regulators of the derivatives market into a cumbersome and potentially dangerous workaround.

Those regulators are feverishly making lots of important, arcane rulings that are being followed only by insiders. They are replacing an opaque system prone to failures with a new, huge Rube Goldberg-like system that may reduce global financial risk. Or it may not. Nobody knows, not least the regulators themselves.

The Commodity Futures Trading Commission, led by Gary Gensler, last month approved rules that would require derivatives clearinghouses to open their membership to firms that have as little as $50 million in capital. A clearinghouse is a central body through which trades take place. It is supported by its financial firm members. For instance, if JPMorgan Chase enters into a derivatives transaction with Goldman Sachs, their deal would go through a clearinghouse, which is on the hook for the trade if one of those banks fails.

The big banks that dominate derivatives trading resisted letting in smaller firms, arguing that doing so would make the clearinghouses vulnerable. They have a point: A clearinghouse with a bunch of undercapitalized members would be more prone to failure, unable to pony up when one side of a trade defaults, and we would be back where we started.

And who had lobbied for this? One of those smaller brokerage firms, MF Global, then run by Jon S. Corzine. Of course, MF Global went belly up because of its aggressive bets and high leverage.

Oops. That disaster makes it easy to conclude that the Commodity Futures Trading Commission is going about trying to reform the derivatives markets all wrong.

But excluding the small fry is dangerous as well. If clearinghouses restricted their membership to only the biggest and best-capitalized firms, the markets would more or less look like they are today — an oligopoly.

Derivatives trading is dominated by the likes of JPMorgan, Goldman Sachs and Deutsche Bank. We now have a financial system where the failure of one megabank can jeopardize the world financial system, and having clearinghouses run by only the “too big to fail” firms merely replicates that fundamental problem.

“If you want to restrict access to just the larger organizations, you don’t solve the problem that clearinghouses are there to solve,” said Nicholas Dunbar, the author of "The Devil’s Derivatives" (Harvard Business Press), a history of the creation of these markets.

So both options are bad; letting in small guys is dangerous, but so is keeping them out.

Another insoluble problem is that of the One or the Many. If there were only one giant global clearinghouse for all derivatives, it might have enough capital to survive a panic in any one corner of the derivatives market. But if a general financial crisis forced many members to default, then it really would be too big to save. No country, not even the United States, would allow such a gargantuan institution to be domiciled on its home turf.

Instead we have an explosion of clearinghouses. We have clearinghouses for different asset classes. We have competing clearinghouses. We have clearinghouses in the United States, Europe and Asia. Dodd Frank implicitly supports this “let a thousand flowers bloom” approach.

That leads to another concern. Clearinghouses create an impression there’s some underlying capital to protect them, either in the entity itself or among the members. But a multiplicity of small ones is dangerous, according to Frank Partnoy, a professor of law and finance at the University of San Diego. The fragmentation means that safety is likely to be an illusion.

“There is less money” in each tiny clearinghouse, he explained. It virtually guarantees that if there’s a panic in one area of the world, the clearinghouse that backs it won’t have enough capital.

The regulatory changes could make things worse in another way, said David Murphy, principal of the risk management firm Rivast Consulting and a former head of risk at the trade group International Swaps and Derivatives Association. Here, it’s worth knowing a little about how banks minimize risks as they trade derivatives.

The underlying amount of derivatives, called the “notional value,” is in the hundreds of trillions. The biggest dealers, like JPMorgan, have tens of trillions of notional value on their books. What we are worried about is counterparty risk: What happens if one of the banks on either side of a trade fails?

As an example, the investment bank Robbin & Steelin has a portfolio with another investment bank, Engulf & Devour. Robbin goes through an exercise to figure out the following:

If Engulf fails, how much would Engulf owe us and what collateral do we have against that?

And how much would it cost us to replace those positions, to restore our offsetting hedges?

That, with a few steps in between and a lot of fancy math, is how those trillions of “notional” amounts shrink to a much smaller “net” figure, in the billions.

But under the clearinghouse regime, the banks will have to split up those gargantuan portfolios. Let’s say Robbin and Engulf had two trades with each other, a European derivatives trade worth $200 and an American derivatives trade worth $180. It has a net value of $20, with Engulf posting that amount in collateral with Robbin.

Now the trades move to clearinghouses. The European trade goes to a European clearinghouse. The American trade goes to an American clearinghouse. The parties need to post larger amounts of collateral. If, say, the European clearinghouse fails, one bank is exposed and now has a much bigger exposure.

Will that bank have received adequate collateral from the clearinghouse? Maybe, but maybe not.

But the bank may have to go out into the market to offset its exposure — possibly a more disruptive move than it would have been under the previous regime.

It’s possible that the netting effects from other trades with the clearinghouse will serve the same function. But it hasn’t been adequately studied.

One possible result of all of this is that there will be less derivatives trading and more collateral going back and forth. That’s bad for bankers, but good for the rest of us.

Given the weak hand that regulators have, however, it seems more likely that the collateral will just be inadequate. It’s easy to see regulators and trading partners falling for the illusion of safety that clearinghouses provide.

“The scary part,” said Mr. Murphy, the risk expert, “is that I’m pretty certain that clearing is being imposed without anyone actually knowing whether it actually reduces counterparty risk or not.”

One sure thing in this morass of uncertainty: We will find out.

Barry Schmittou

Nov. 16, 2011, 8:41 p.m.

U.S. Government leaders will cause the Dodd-Frank regulatory overhaul to be another way for the elite to rip off average citizens for trillions more.

We can’t trust anything the government does because :

(1) Wachovia Bank laundered $378 billion for Mexican drug cartels that are responsible for 35,000 murders. No one at Wachovia was prosecuted by Obama’s DOJ !!

(2) Bank of America, American Express Bank International and Western Union also laundered drug money and no one was prosecuted.

The New York Times wrote :

“Bank of America acknowledged its lax operations allowed South American money launderers to illegally move $3 billion through a single Midtown Manhattan branch, closing the latest illicit-finance investigation brought by Robert M. Morgenthau, the Manhattan district attorney.”

“No indictment was sought “because we don’t want to put banks out of business,” Mr. Morgenthau said.”

(3) AIG, JP Morgan Chase, MetLife, Prudential, Unum, rigged huge bids and no one was prosecuted!!

(4) Major insurance companies (including MetLife) that contributed to Obama and Bush are endangering claimant’s lives in multiple types of insurance by ignoring life threatening medical conditions including brain lesions, Multiple Sclerosis, cardiac conditions of many patients, and a foot a new mother broke in five places.

At the same time two MetLife executives gave Obama huge contributions and they both signed MetLife’s third Non prosecution agreement for committing frauds to increase their sales of these exact policies !!

Bush protected AIG’s huge bid rigging of Workers Comp policies !!

See links to government documents and other evidence by pasting :

Since the U.S. government protects corporate criminals we can be sure trillions more will be stolen because of the Dodd-Frank intentional mud !!

Walter D. Shutter, Jr.

Nov. 17, 2011, 8:59 a.m.

In the movie “Magnum Force”, dirty harry Callahan made the famous observation: “a Man’s got to know his limitations.” 
Knowing that something exists is not the same thing as understanding how that thing works.
I don’t understand: Quantum Mechanics, Relativity, both General and Special, and DERIVATIVES, just to name a few things.
That said, I can see no reason why the US Govt. should use my tax money to bail out those who placed their bets and lost.  That’s what the Bankruptcy Code is for.

It’s not a matter of big guy/small guy, it’s a matter of abstraction.

Some derivatives are useful to the economy at large and make certain industries feasible:  When Intel buys insurance against the rising cost of silicon or copper, or when a company signs a multi-year contract to “lock in” the price of heating oil, they’re stabilizing their corner of the market and forcing costs to a certain level of predictability.  Those are good things, I think we can agree.

The problem is that, the further we step from the real world and the more we commoditize the derivative itself, the more the market acts against the “real” derivatives.  That is, when a hedge fund buys an insurance policy (or mortgage) and insures against the policy’s non-payment (or worse, doesn’t buy the policy, but takes out insurance anyway) or when Goldman-Sachs buys grain futures without any intention of buying the actual food, those acts are blatantly destructive to the economy.

Most of those destructive actions, not coincidentally, involve acts that are crimes, like insurance fraud, market manipulation, insider trading, and often breach of contract.

As much as economists want to tell us how complicated and difficult the field is to understand, we’re talking about very simple ideas merely taken to extremes by Goodfella wannabes in power ties.

I can’t guarantee the solution is easy or obvious, but it seems to me that you’d want to replace the “derivatives market” with a public, open registry of derivative contracts, and prosecute any trader (and his employer) for any illegal action taken in the course of turning a contract into profit or for making a contract without registering it.

Jesse Eisinger

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