Can we stop the new derivatives loophole?

Barney Frank's reform bill gets another amendment that would defeat its main purpose. But the Internet is watching

By Andrew Leonard
December 10, 2009 12:18AM (UTC)
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If you agree that one of the building blocks of the financial crisis was the decision to exempt large swathes of derivatives trading from regulatory oversight -- codified in the infamous Commodities Futures Modernization Act of 2000 -- then you probably have been paying reasonably close attention to House Financial Services chairman Barney Frank's efforts to shepherd new derivatives regulation into law.

Depending on which lobbyist or activist you talk to, the bill has been variously described as heavy-handed profit-killing government interference with efficiently functioning markets, a bound-to-fail toothless attempt to restrain Wall Street irresponsibility that has already been gutted, or the last best chance to actually bring sense and order to the wild and woolly world of derivatives. Barney Frank, meanwhile, is either the bought-and-sold tool of Wall Street or a marauding socialist, or to take him at his own word, not quite capable of understanding the complexity of his own bill.


What makes this particular bill -- H.R. 4173, Wall Street Reform and Consumer Protection Act of 2009 -- at this particular moment in time so interesting is that never before have we had so many eagle eyes watching every move legislators and lobbyists are making. We are watching the sausage get made, in real time. I don't think it is hyperbolic to say that the future health and prosperity of our democracy hinges on whether or not we can lever the Internet's hydra-headed watchdog abilities into an effective  force for change.

Here's the latest, in what looks to be a pretty important post by Rortybomb's Mike Konczal, published moments ago at The Baseline Scenario. The bottom line is that it appears that yet another attempt to render the legislation powerless is underway, just as the bill hurtles towards a vote.

I'm going to republish Konczal's post in full. It's complicated, it's wonky, and it's the kind of thing that for most of our lives  has rarely seen the light of day as the House and Senate go about their business. But we should all be talking about it, because the wider this news spreads, the more pressure there will be on mainstream media to follow up, and the better chance we will have of shaming the real tools of Wall Street:


Have lobbyists snuck another major loophole into the OTC Derivatives bill? This week the final touches are being put on Barney Frank's financial regulation bill -- H.R. 4173 -- "Wall Street Reform and Consumer Protection Act of 2009." One of the centerpieces of this reform is Title III: Over-the-Counter Derivatives Markets Act. And one of the goals of this reform would be to get as many derivatives as possible to trade on exchanges.

An initial hurdle for Barney Frank was what to do with an "end-user exemption." This would exempt certain types of derivative buyers who use derivatives, say corporations hedging interest rate risk without speculating, from the extra scrutiny and regulation that comes with the exchange/clearing system. One of the narratives of financial reform so far has been that this initial end-user exemption was too large a loophole at first, and instead of just handling 10-20 percent of the market, it would let a large majority of the market sneak through, but ultimately Barney Frank was convinced by consumer groups and people pushing for stronger financial regulation and fixed this issue. See Noah Scheiber here in "Could Wall Street Actually Lose in Congress?" for this story, and it shows up as well in a recent profile of Barney Frank in Newsweek.

I thought it was a little too early to declare victory, and sure enough instead of attacking and weakening how people will have to use the exchanges, lobbyists have re-focused their attack on the idea of the exchange itself. For a while, reformers have been worried about an "alternative swap execution facility." This would be a way of essentially allowing the current way things are done to be allowed to count as an exchange. Fighting off this loophole was a battle from a month ago, and it had appeared to be won. Now many are worried that this language appears to have snuck back into the final bill now.

Colin Peterson (D-MN), Chairman of the House Committee on Agriculture, along with Barney Frank, has added an amendment to the OTC Bill (opens large pdf). There are two relevant sentences for reformers from the long document. The first is on page 32:

(49) SWAP EXECUTION FACILITY. -- The term 'swap execution facility' means a person or entity that facilitates the execution or trading of swaps between two persons through any means of interstate commerce, but which is not a designated contract market, including any electronic trade execution or voice brokerage facility.

This replaces other language in the original bill (opens even larger pdf), on page 546:




(A) No person may operate a swap execution facility unless the facility is registered under this section.

(B) The term 'swap execution facility' means an entity that facilitates the execution of swaps between two persons through any means of interstate commerce but which is not a designated contract market.

So notice any differences? First the definition of a swap execution facility has been expanded to include "a person" (different from the "or entity"). It's also expanded to an "or trading" definition, and includes voice brokerage firms. So now we are moving from the definition of something that is a platform for swaps to be traded on to instead something that simply helps swaps get traded. This could, quite simply, be a telephone over which two people trade a derivative (with one person declaring himself to be the exchange?). Instead of changing the way business is done for reform it looks like it redefines reform as the way things are currently done, and just calls it a victory.

Now on page 89 of the amendment:


Not later than 1 year after the date of the enactment of the Derivative Markets transparency and Accountability Act of 2009, the Commission shall adopt rules to allow a swap to be traded through the facilities of a designated contract market or a swap execution facility. Such rules shall permit an intermediary, acting as principal or agent, to enter into or execute a swap, notwithstanding section 2(k), if the swap is executed, reported, recorded, or confirmed in accordance with the rules of the designated contract market or swap execution facility.

The second sentence here allows an intermediary to execute a swap, ignoring the section 2(k) which is the meat of the reform, as long as the swap is recorded somewhere. Now we already have, from above, that a swap execution facility can be something other than the exchange. This is a rule that guts the regulation right out the door, and for no apparent benefit to reform. Many of these alternative swap facilities will be owned by the banks, so it won't necessarily force the price transparency that has been promised. To trust regulators to simply do the right thing is naive at best when the ability to follow fixed rules is available.

From what I'm hearing, it is possible Frank doesn't even know that this language, once in the bill as an amendment but removed, has snuck back into his reform legislation. Things are moving very quickly on the hill right now, and this is scheduled to be wrapped up by tomorrow. However this new language runs counter to the reforms Frank has promised to deliver to the American people. Either this language needs to be clarified before the bill is complete, or removed entirely.

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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