Getting the Hill out of the Street

My thoughts on the Senate’s passage of Financial Reform – originally posted on

The US Senate has passed its version of financial regulatory reform that will include serious changes, some expected, some not, specific to the OTC derivatives market.  The passage of this bill will lead to a compromise bill created jointly by the House and Senate and ultimately President Obama signing it into law before 4th of July barbeques are under way.  Although its contents are questionable, getting the bill out of the Senate is a good thing as the Hill will finally be removed from the Street.

But as we’ve learned during the entire, multi-year reform process, the devil is really in the details and unfortunately many of the details continue to be a bit hazy.  At last check, there were 434 proposed amendments to the Senate bill.  Most of these amendments will fall by the wayside now as the Senate was anxious to move the process along, but sorting out and knowing what’s in, what’s out and what replaces what may well require a gaggle of Congressional staffers.   Even with the final text made clear,  most of us at TABB Group are left trying to decipher the “spirit” of the law.

I am not a congressional staffer (I prefer the subway frankly, not the Metro) but what follows are several of the key OTC derivative reform issues and where they stand.

Senator Blanche Lincoln put forth an amendment to replace the original OTC derivatives reform text in the Dodd Bill.  It is the contents of the Lincoln Amendment that provides the Senate’s plan for OTC derivatives. Although the plan is similar to what the House passed in December 2009, it creates a more onerous (and market-growth inhibiting) structure for OTC derivatives.  One provision within that amendment stands out above the others, and will continue to be the source of great debate as the bill goes to committee.

Senator Lincoln proposes that banks that trade OTC derivatives would no longer be allowed access to the Fed, FDIC or other emergency funding sources for banks.   What this means in practice is that banks would need to spin off their swaps businesses into separate legal entities, a provision that is not good for the market, period (but that is a debate for another time).

We have learned through various sources that this provision may yet be dropped when the Senate and House meet to create a compromise bill.  The support for this particular provision of the bill has decreased dramatically in Washington during the past weeks, making it less likely the proposal will become law.  However, given the poor optics of being soft on banks, the escalating punitive nature of the regulation in recent weeks, the impending election and the stick nature of the Lincoln Amendment despite lobbying efforts the fate of this provision will remain unclear until a compromise bill is approved.

The so-called Volcker Rule that would ban banks from engaging in proprietary trading is also included in the Senate bill, despite the defeat of an amendment that would put additional restrictions on how banks trade with their own capital.  Although this provision seems too extreme to make its way into the compromise bill, populist fervor and support from other prominent politicians makes possible some ban on proprietary trading at banks.  This would have significant implications to bank earnings and the prominence of the US in the global capital markets.

Mandates for central clearing and trading through a registered execution venue are a near guarantee as both the Senate and House (not to mention Democrats and Republicans) see these moves as necessary to increase transparency and therefore reduce systemic risk.  Exactly who falls under these mandates, however, continues to be a source for debate.  The Senate bill provides few exemptions as compared to the House bill and would likely force firms with no systemic importance to centrally clear certain trades, which means they would need to put up additional margin, ultimately putting an undue burden on these organizations’ balance sheets.  The exact wording of the law is also important.  For example, if Swap Execution Facilities are defined as “trading facilities,” then technically, phone-based transactions would become illegal based on the definition in the Commodities Exchange Act.

Other amendments that passed increase the CFTC’s power in dealing with market manipulation, raise capital standards for banks trading OTC derivatives and put heavier regulations on the trading of mortgage-related derivatives.  One notable amendment that was not passed was a proposed ban on the trading of naked credit default swaps.  We’ll leave that to Germany for now.

For the next month, all eyes will be on the discussions between Representative Barney Frank and Senator Chris Dodd as they work out a compromise bill.   The Lincoln proposal to spin-off swaps desks, a potential proprietary trading ban and far-reaching clearing and execution mandates could be game changers for the entire market based on the bill’s final wording.  K Street lobbyists will remain close to the Hill to push for these proposals (such as those by Senator Lincoln to spin off bank swap desks and the Volcker Rule), to die.

The debate will not end at President Obama’s desk.  As I’ve discussed in previous papers, the rule-writing process at the CFTC and SEC will become the next focus as regulators work to implement the laws passed by Congress.  Keep an eye out for comment periods and continued fierce debate.

While the House bill may be closer to a realistic solution than the one passed by the Senate, the Senate bill may be closer to what gets passed, given the current, charged political environment and the pressure not to side with the banks.

TABB Group believes that the bill that passes will go inevitably too far in some cases, likely making the clearing mandate, for example, impact more firms that is necessary to reduce systemic risk.  Unfortunately, this situation has become more about politics (bipartisan issues, reelections, etc.)And less about market structure.

Some reform is good, but going too far will be just like putting your car up on cinder blocks to ensure it doesn’t get into an accident.

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