Blanche Lincoln's Excellent and Doomed Derivatives Proposal

by: Felix Salmon

There’s a fair amount of confusion over the new derivatives legislation that Blanche Lincoln is planning to introduce tomorrow, and partly that’s because a lot of DC journalists don’t really grok the distinction between exchange clearing and exchange trading. (It’s a pretty recondite distinction, I hardly blame them.)

The easy way to think about this is that if an instrument is exchange-traded, then it will always be cleared by the exchange as well. It’s possible to have central clearing of derivatives transactions without having them exchange-traded, but you can’t have exchange trading without central clearing.

Lincoln wants to mandate exchange trading for most derivatives, although it looks as though she might give the CFTC final say on that front. If a company gets an exemption from having to clear its trades centrally, then, it will also have to get an exemption from the exchange-trading rules. And so Lincoln wants to make those exemptions very rare indeed.

Lincoln also wants to regulate foreign currency swaps, in a move which goes further than even Treasury wants to go. And more generally, in a Volcker-like move, she wants the big investment banks’ swap desks to be spun out of their bank parents, to prevent contagion and to help make them small enough to fail.

I think that’s a great idea, since at a stroke it would solve a lot of the interconnectedness problems which worried Treasury and the Fed so much during the financial crisis. And it’s a robust, Roman solution.

But it’s also pretty clear that none of this is going to happen. Never mind Republican support: this is going to have a hard time even getting Democratic support. It’s all a good idea, but it’s far too radical: while it might have had more of a chance if it had been introduced during the height of the crisis, at this point the banks have got their mojo working again and will quite easily be able to ensure that the beating heart of Lincoln’s proposals is surgically excised before it even gets anywhere near a vote.

And when even the exchanges themselves no longer want exchange trading of derivatives, it’s going to be hard to find any constituency at all in favor of these proposals.

Which is a shame, because I’d love to see something along these lines happen. I suppose there’s some hope that if Lincoln starts off very aggressive in her proposals, that will help them retain some teeth by the time they get incorporated into the final bill. But I’m not holding my breath.