On OTC Derivative Reform: In Support of the Lynch Amendment

The OTC derivative market is one of the crucial points of reform. Noam Scheiber has good news, Could Wall Street Actually Lose in Congress?

The proposal the Obama administration unveiled this summer would have forced banks and hedge funds to trade derivatives on exchanges and “centrally clear” them. Clearing means inserting a well-capitalized middleman between two parties on either side of a trade….In order to ensure [OTC regulation] eventual passage, Frank found himself having to strike a deal with a group of moderate New Democrats on his committee…

But independent experts who studied the measure came to a different conclusion: that it could exempt between 60 and 80 percent of the standardized market because of its vague wording, including many firms who were speculating rather than simply hedging risk…

But a funny thing happened on the way to securing the loophole: A confederation of consumer and investor groups, labor unions, environmental activists and a progressive organization called Americans for Financial Reform (AFR) started raising hackles of their own….By early this month, the pressure from Gensler and the progressive groups had the desired effect. Though Frank believed their concerns were somewhat overblown, he pronounced himself open to tightening the language to make sure the bill didn’t give speculators a pass.

This is good news. But just because we made first down on 4th and 10 doesn’t mean we are done driving the ball. I want to discuss my new favorite financial reform amendment. This one is pretty awesome: Amendment by Mr. Lynch, no. 7, H.R. 3795, Over-the-Counter Derivatives Markets Act of 2009.

The Problem

Background: There is a move to have OTC derivatives brought to exchanges. This will allow for a more even playing field, removing opacity and information problems inherit in the market. Smaller firms will be able to compete on prices, adding liquidity and decentralizing the risks of our financial markets. To the extent that private contracts need to be made, the exchange can set extra rules for those trades to make them available but discouraged.

So pretend you are the CEO of a large financial firm, who wants to manipulate this situation. What’s the obvious move?

Think of it yet?

Why not just buy the exchange?

It’s a private entity, not a government agency. And the owners get to set all the margins and all the rules which will make this competitive (or not). Right now the OTC derivative market is heavily dominated by a few financial firms, with 5 firms (1. JPMorgan Chase (JPM), 2. Goldman Sachs (GS), 3. Bank of America (BAC), 4. Citibank (C), 5. HSBC (HBC)) accounting for 97% of the notional amount of all derivative contracts. And four out of five of those banks are TARP recipients, so they have gotten some cheap capital that they could be looking to invest.

So here’s a simple amendment, by Stephen Lynch (D. Mass). Here’s the crucial part of it:

(B) BENEFICIAL OWNERSHIP BY A RESTRICTED OWNER – The rules of a clearing agency that clears security-based swaps shall provide that a restricted owner shall not be permitted directly or indirectly to acquire beneficial ownership of interest in the agency or in persons with a controlling interest in the agency, to the extent that such an acquisition would result in restricted owners controlling more than 20 percent of the votes entitled to be cast on any matter by the holders of the ownership interests.

Financial firms can’t own more than 20% of the exchanges. That’s it. No Exchange Czars. No additional government regulator to fall asleep at the wheel. No complicated Rube Goldberg device with a “let’s nudge someone to do something with taxpayer money” payoff structure. Competition. People looking out for their own money. Level playing field. Simple, good ideas. Let’s have a large number of market participants, looking out for their own interests, owning these things, instead of a subsidiary of the largest banks. Because in that case, we don’t need to invoke a metaphor for regulatory capture, say ‘cognitive capture’ or ’social capital’; it wouldn’t be a metaphor – they’d actually own the mechanism we expect to regulate them.

Breaking this amendment on the floor is going to be a rallying point for the largest business interests. The Securities Industry Financial Markets Association (SIFMA) and International Swaps and Derivatives Association (ISDA) are already opposed, saying, of all the wonderful things, that it is “anti-competitive.” And the fighting and lobbying is going to get more intense for Lynch and those who want to support this amendment.

Competition

This amendment should move you if you believe (a) the largest banks have a concentration of political power and need to be curbed and (b) the government should be in the business of defending markets, not big businesses. Left or right doesn’t matter much here since they have the same concerns. Here’s Luis Zingales’ An Economic Agenda for the GOP (h/t Reihan Salam):

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks, for instance, benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange: they can charge wider spreads that way, and they can afford to post less collateral by using their credit ratings. For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity, and collateralization—and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else….For every “zombie” firm that survives because of government assistance, several innovative start-ups don’t get the chance to be born. Subsidies, then, hurt taxpayers twice.

People think of finance as a single thing, but there are small firms, innovators, people looking to pick up the slack somewhere and make some money in the process. Read those last two line from Zingales, and then re-read the email from my friend at the end of my post on liquidity and TBTF:

We know that the banks make huge spreads in trading OTC products and we were looking forward to performing our patriotic duty of competing these spreads away [in a small new firm]. It looks like it will never be.

The market can handle this, as long as it is able to function as an actual market. And that means the biggest firms don’t buy the exchanges with TARP money and set the rules.

Anyone, progressive or conservative, who supports the idea of free and more equitable financial markets should take a minute out of their next few weeks and show support for this amendment. Blog about it. Write and call your representative when it gets into a fight on the floor. Write and call them now. Maybe 10,000 people will read this post over its life. The Financial Services Industry will spend well over $200 million dollars this year lobbying. That’s $20,000 per person that reads this, or about half the median income. I sadly can’t ask you to donate that much – I can ask you to get involved however.