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Loophole Alert -- Lincoln's Derivatives Language Perhaps Not All it's Cracked Up to Be

May 16, 2010 - by Donny Shaw

In the House, derivatives reform was gutted by a loophole that allows any bank to declare themselves a “swap execution facility” and simply make a trade over the phone. Now, the derivatives reform section in the Senate financial reform bill, which is generally considered one of the bill’s toughest sections, is at risk of being rendered useless by its own loophole. This one would let banks dodge new clearing requirements without any negative consequences, even if they have been told by regulators that they must conduct their trade through a clearinghouse.

Shahien NasiripourShahien Nasiripour at the Huffington Post reports on an email to the Senate Banking Committee from Americans for Financial Reform warning them of the loophole.

The financial regulatory reform legislation, which is being shepherded through the Senate by Banking Committee Chairman Christopher Dodd (D-Conn.), attempts to rein in the OTC derivatives market by mandating that most trades go through a clearinghouse, a facility that executes trades for parties that are required to post collateral and mark their positions daily to prevailing market prices. So, rather than two financial firms trading with each other — with no oversight — they’d now have to go through this central point. It would shed more light on the market and allow for government regulators to more effectively police it, reformers and Obama administration officials argue. […]

The problem, however, is that there’s apparently little consequence if firms evade the requirements, according to the email sent to a Banking Committee staffer by Americans for Financial Reform, an umbrella organization of consumer advocacy, public affairs and union groups arguing for reform. Some of these potential loopholes were first identified by Zach Carter of AlterNet.

“[T]here is no consequence for counterparties who enter into uncleared swaps even after a finding by the [Commodity Futures Trading Commission] or [Securities and Exchange Commission] that the swaps must be cleared,” the email reads. The bill “does not prohibit the use of uncleared swaps and, even more egregious, expressly states that no swap can be voided for failure to clear.”

In other words, if parties to a swaps contract — a type of derivative that involves regular payments over a specified time period — do not trade via a clearinghouse when they’re supposed to, there’s no penalty, the group argues. Also, those swaps can’t be deemed invalid because of this evasion.

Ultimately, the Commodity Futures Trading Commission would get to determine what the penalty would be for trading a swap directly that was required to be traded through a clearinghouse. Nothing in the bill requires the CFTC to establish or enforce a particular penalty for dodging clearing requirements.

Even if the CFTC does decide to go after swap dealers that don’t obey the rules, the bill is set up to allow the big banks to pretty much game the whole system, AFR explains in their email. The bill states that swaps cannot be deemed invalid for trading because they have been rejected for clearing by a Futures Commissions merchant. The problem is that the big banks that are doing most of the swap trading actually own the Futures Trading Commissions, so they could, in effect, decide to reject one of their swaps and then trade it legally without having to go through a clearinghouse. This is in addition to the fact that they maybe will be able to dodge clearing requirements without penalty anyways.

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