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While You Were Sleeping ...Congress Regulates the $600 Trillion Derivatives Market

June 25, 2010 - by Donny Shaw

The conference committee worked through the night until 6 a.m. this morning to finalize their financial reform bill and, in particular, its critical language regulating the huge and risky over-the-counter derivatives market. I stayed awake until about 3:00 a.m., following along to the extent possible on C-Span and providing updates on Twitter, but I was asleep before any good info or analysis was really available. Now that we have some day-after reporting on what happened in those delirious early morning hours, after all but a handful of people had turned off C-Span, here’s what it looks like went down.

Volcker Rule — This ban on banks investing their own money for profit rather than investing for their clients, so-called proprietary trading, wasn’t in either the House or Senate versions of the bill. But the conference committee inserted it into the final bill last night, albeit with an exception designed to win the support of Sen. Scott Brown [R, MA] allowing banks to invest up to 3% of their Tier-1 capital in hedge funds. The inclusion of this language in the bill is a big victory for reform advocates, and one that was not at all expected just a few weeks ago.

Lincoln 716 — This is a section from the Senate version of the bill designed to stop banks from getting taxpayer subsidies for their risky derivatives trades. It’s practical effect would be to force banks to spin off their derivatives desks in to separate entities that would not have access to federal assistance via the Fed discount window and the FDIC. This section made it into the final bill, but with a gigantic loophole in it. Under a late night deal brokered by Rep. Collin Peterson [D, MN-7], banks would be allowed to continue receiving federal subsidies for all interest-rate swaps, foreign-exchange swaps, investment-grade credit default swaps, gold and silver swaps, and anything deigned to hedge risk. Interest rates swaps alone make up well more than half of the derivatives marketplace. And with the ambiguity implicit in trading fro risk hedging, probably somewhere around 90% of all derivatives trades will still get federal backing from the Fed and FDIC. The chart on the right (provided by Ilan Moscovitz at Fool.com) shows the extent to which this was gutted. The green is interest rate swaps and the orange is foreign exchange contracts.

Bank Tax — Since Republicans managed to kill the idea of a pre-funded orderly liquidation fund in the Senate by falsely labeling it a bailout fund, the conference committee had to find some revenue in order to make the financial reform bill be budget neutral and comply with pay-go rules. They settled on a risk-based assessment on the largest banks, which is expected to raise $19 billion over the next ten years.

Clearing and Exchange Trading — It appears that the majority of derivatives would have to be approved by clearinghouses and traded on exchanges with margin requirements and pricing transparency in the final bill. These requirements from the Senate version appear to have remained pretty solid without any of the giant loopholes from the House version influencing the final bill.

The final text of the bill is not available yet, so you can expect a lot more detailed analysis in the near future as soon as folks are able to dig into the actual language. The Democrats have pledged to have the text online for 72 hours before it gets its final votes in the Senate and the House.

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