Why Dodd's Derivatives Reform Bill Is Likely to Become Law

by: Craig Pirrong

No, it’s not that both can make you cry. It’s that if Sen. Blanche Lincoln (D-AR), chair of the Senate Ag Committee has her way, futures trading on both will be banned. Onion futures have been banned since 1958, and the passage of Public Law 85-839 (legislation spearheaded by Gerald Ford, by the way). Since that time, onions have had the dubious distinction of being the only commodity in which futures trading is specifically banned. Now, the draft of Lincoln’s derivatives regulation bill would give onions company, by proscribing futures trading on

motion picture box office receipts, or any index, measure, value, or data related to such receipts.

Now you could make a case–a weak one, but a case nonetheless–for the onion ban. There were periodic manipulations of onion futures in Chicago. Onions are perishable, and short sellers would sometimes bring in a few extra carloads of onions and deliver them. Due to the perishability, a modest enhancement in supply would crater the price, generating a profit for the futures short. There are stories that the price of onions would fall below the cost of the bags they were delivered in.

That said, empirical studies of the effects of the ban have shown that the ban did not reduce the volatility of onion prices. Thus, the ban didn’t have any measurably beneficial effect. But the CME (where onions were traded) has moved onto other things, and the market isn’t big enough to make it worth anybody’s while to lobby Congress to get the ban lifted. So it has remained, a quaint curiosity.

Given that movie futures haven’t even started to trade yet, dire stories of adverse effects are, pardon the pun, mere speculation. But a visible, connected, and influential interest group, that just happens to give Democrats in particular large sums of money, supports a ban. So it made it into Lincoln’s bill, and into the news, ironically, on the day that the CFTC gave initial approval for such contracts.

But oh, were this the worst part of the bill. As it is, it is merely a visible, risible, symbol of just how bad the bill is. I will blog more on it later, but it has all the bad things in the Dodd and Frank bills, and much more to boot; it is the Dodd bill on steroids–or meth. It is chock-full of anti-bank populism. Most notably, it precludes any swaps dealer from having access to the Fed window. As if banks can’t get themselves in financial trouble the old fashioned way, with no derivatives involved.

(It would be interesting to hear an explanation of how, if derivatives dealing is as obscenely profitable as Timmy! and Gensler and various Congresspeople argue, depriving banks of this revenue is going to make them healthier and less likely to require government help.)

Moreover, although the Lincoln bill mandates clearing, and offers only very limited exemptions from the clearing requirement, it also denies clearinghouses access to the discount window. Even those broadly supportive of wider use of clearing recognize the potential systemic issues, and recommend that clearinghouses have access to central bank liquidity facilities. But Stella–I mean, Blanche–thinks differently. (Maybe somebody should tell her about the near death of the CME and CBT clearinghouses on 20 October, 1987.)

Let’s see, Congress creates systemically important institutions that concentrate risk by mandating clearing, and then deprives them of access to the lender of last resort whose responsibility is to provide liquidity to systemically important institutions in times of crisis. Just how is that supposed to work?

It was widely thought that Lincoln’s bill would be more moderate than Dodd’s but the reverse turned out to be true. Some reporting suggests that she was near a compromise with her committee’s ranking Republican, Saxby Chambliss, but that the White House pressured her to back off. The administration certainly made derivatives regulation a centerpiece of its rhetoric last week, and has evidently decided that anti-bank, anti-derivatives populism is a winning political issue that will put Republicans in an uncomfortable position. Lincoln is in trouble in her re-election bid, so she could use the populist cred too.

It has all the appearances of a good cop-bad cop routine. Don’t like the Dodd bill? Just look how bad the alternative is. Sad to say, I think that this means that the Dodd bill, or something close to it, is likely to become law.