March 31, 2010 | WebMemo on Financial Regulation
Eighteen months after the financial crisis, Senator Chris Dodd (D–CT) and the Obama Administration are suddenly in a hurry to pass financial reform legislation, including blanket regulation of over-the-counter (OTC) derivatives. Dodd’s derivatives proposal, as adopted by the Senate Finance Committee last week, ignores changes in derivatives markets following the financial crisis, thus amounting to legislative bank-bashing.
The test of any derivatives market reform proposal is whether it recognizes the substantial changes in the structure and operation of those markets in the prior 18 months. The current Dodd language fails this test on four grounds:
Derivatives and the Financial Crisis
Many derivatives, such as those related to stocks and commodities, are already traded on exchanges and regulated as traditional securities. Prior to the financial crisis, however, significant categories of financial derivatives—principally those related to interest rates, foreign exchange, and debt (credit default swaps [CDS] on bonds)—were traded OTC directly between major banks.
Losses on financial derivatives at Lehman Brothers and AIG were key events in the financial crisis of 2008. Moreover, some observers believe lack of information about derivatives exposures of major banks contributed to the freeze-up of credit markets in October 2008. This is not to say that derivatives caused the financial crisis; rather, ill-advised uses of derivatives and imperfections in OTC derivatives markets represented weak points at which the crisis was manifested most intensely.
Consensus on Improvements
There is significant consensus among derivatives market participants and regulators about the desirability of improving market infrastructure, enhancing financial stability, standardizing products, and providing transparency for market participants, the public, and regulators. There is further agreement that central clearing and exchange (or otherwise open) trading are important means of achieving some of these goals.
How Markets Have Reformed
Operating under the aegis of the Federal Reserve Bank of
These and other steps amount to a huge and rapid evolution of a complex market. This magnitude of change was possible with minimal disruption because market participants themselves planned and implemented the changes. Replacing this market-driven process with command-and-control regulation, as Dodd proposes, will slow the pace of productive change and result in less satisfactory outcomes for the very policy goals Dodd and regulators seek.
The Dodd Bill’s Failures
Top-Down Mandates. The Dodd bill requires every derivative transaction, buyer, seller, or trader to be regulated by bureaucrats. Policy should focus on goals rather than means, leaving markets to devise optimum ways to address legitimate policy concerns.
One Size Fits All. Central clearing has multiple benefits. But not every derivatives trade can or should be centrally cleared. For instance, central clearing may deprive some derivatives users of significant hedge accounting tax benefits. Mandatory clearing may also interfere with certain bank capital rules.
Given reasonable flexibility, users and regulators can address the interplay among securities, tax, and bank regulations and commercial needs. A universal clearing mandate with a complex exemption process is certain to produce unintended consequences.
Bureaucratic Boxes. Because the first derivatives related to commodities and stocks, they were regulated by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). OTC derivatives are related to financial products traditionally offered by banks. Dodd’s bill mandates joint regulation of derivatives by the CFTC and SEC for no better reason than existing bureaucratic jurisdiction.
The New York Fed effort shows that banking regulators can supervise these bank-related markets rather than requiring them to conform to bureaucratic categories. Dodd’s draft, on the other hand, simply protects turf in
Behind the Curve. Dodd’s derivatives provisions ignore the substantial changes in markets since 2008. Because markets move more quickly than do regulations, it is impossible for detailed legislation to keep up. Micro-managerial mandates will slow the pace of reform and likely misdirect it.
For instance, market participants have requested specific legislation to ensure the legal safety of derivatives trades in clearinghouses. The Dodd bill imposes a complex clearing mandate but ignores the request for simple legal changes required to ensure the safety of those trades.
Deriving Better Solutions
Dodd indicates that his derivatives proposal is likely to be replaced, possibly by a bipartisan compromise from Senators Jack Reed (D–RI) and Judd Gregg (R–NH). A serious effort to improve derivatives markets would:
Rapid reforms in derivatives markets since 2008 have made command-and-control regulation represented by the Dodd draft redundant. Lawmakers should understand that imprudent regulations, such as top-down mandates and inflexible rules that inhibit the private market, are worse than no regulations at all.
David M. Mason is a Senior Visiting Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
[ 1] A derivative is a financial instrument whose price is determined by reference to an underlying asset, such as a stock, bond, currency, or commodity. Derivative prices often move in asymmetric or inverse relationship to the price of the underlying asset.
The bill can be found at http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf (
For a list of New York Fed actions on derivatives, see Federal Reserve Bank of
 See Stuart J. Caswell, Managed Funds Association, letter to Deputy Treasury Secretary Neal S. Wolin, February 12, 2010, at http://www.managedfunds.org/downloads/Bankruptcy_Letter_to_Deputy_Secretary_Wolin_final.pdf (March 30, 2010).