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Shuffling Derivatives Reforms

June 3, 2010 - by Donny Shaw

In the final days of the Senate’s work on the financial reform bill, something shocking happened. Over opposition from the banking industry, the White House, the Fed and most members of Congress, Sen. Blanche Lincoln [D, AR] managed to keep alive a provision she had written requiring banks to “spin-off” their derivatives trading operations into separate entities that would not have access to discount Fed money and an FDIC guarantee if they get in trouble. Because Lincoln was (and still is) in the middle of a tough primary race with a progressive challenger, the provision managed to stay in the bill that was passed by the Senate.

As the House and Senate get ready to start negotiating a final compromise version between their two financial reform bills, the Financial Times is reporting that Lincoln’s “spin-off” proposal is item #1 on the chopping block: 

Lawmakers return from recess next week to merge bills passed by the House of Representatives and Senate, and a proposal – opposed by banks – to toughen a ban on proprietary trading and stop them from betting against products they sell to customers has re-emerged during preparatory work.

The provision, sponsored by Jeff Merkley and Carl Levin, two Democratic senators, would toughen the “Volcker rule”, which bans banks from trading for their own account or owning hedge funds and private equity firms, but gives regulators time to study the rule and modify it. “That is a very wishy-washy way to approach the issue,” Mr Merkley said.

Mr Levin said even though the Treasury would “probably…want as much power as they can get to…modify [the bill]”, he thought Congress should write a strong final version.

“Merkley-Levin in general is very much alive,” Mr Levin said. “The proprietary trading provisions from a legislative perspective are very much in the mix.”

Others involved agreed with that assessment and said the proposal could be used to replace a provision by Senator Blanche Lincoln that would force banks to spin off swaps desks.

That is opposed by the Federal Reserve, the Federal Deposit Insurance Corporation and the industry, which argue it would prevent legitimate hedging activity, but it has emerged as a totem of liberal Democratic members of Congress.

It sounds like Lincoln’s provision is going to be used to give conference committee members room to add the Merkley-Levin language (a.k.a. the “Volcker Rule”) to the final bill even though banks and Senate Republicans managed to block it from getting a vote during the Senate debate.

Congressional rules require conference committees to stay within the boundaries of the bills they are reconciling. They can choose the House or Senate version of a provision, or work out compromises between them, but they can’t go beyond what was included in either bill. In this case, it looks like the Merkley-Levin prop-trade ban language is going to be considered a compromise between the House bill, which doesn’t include any structural reforms to banks’ derivatives activities, and the Lincoln language in the Senate bill.

Basically, the compromise here would be that banks will no longer be allowed to conduct trades for their own profit, but they will still be allowed to get a Fed/FDIC backstop for derivatives trades that they execute for their clients.

Reform advocates will be disappointed with this, but given the usual course of legislative activity, this is actually a significant victory for them. The Volcker Rule entered the debate as a sort of fringe idea that was tougher than what the Democrats designing the reform legislation were considering. And then the Lincoln language entered the debate later on as an even fringier idea. From the beginning, it looked like a sacrificial lamb that was designed to be chopped off as soon as some sort of compromise was necessary for the bills’ derivatives title to move forward. No one expected it to get this far in the process, and the fact that it did puts the conference committee in a position to add tough derivatives language that didn’t get a vote in either chamber the first time around.

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