Four "Drive your Truck through it" Loopholes in Dervatives Reform

While we are still reading an analyzing what is in the final bill, Seeking Alpha has a great outline post on the lack of reform on derivatives and identifies four glaring loopholes.

The risk to our financial system must be eliminated, not simply regulated. We as Americans should not tolerate our system being put at risk. All OTC derivatives should clear through a Central Counterparty (CCP) with novation and daily margin, so that all swaps counterparties are forced to make good on their bets every day. In addition, all derivatives that can trade on a public exchange should trade on a public exchange so that regulators have real-time transparency and the ability to police these markets for fraud and manipulation.

Please read the entire article for the details on these four loopholes listed below:

  1. Foreign Exchange Exemption
  2. End-User Exemption
  3. “Balance Sheet Risk” Exemption
  4. Alternative Swaps Execution Facility (ASEF)

Author Adam White calculates just these 4 loopholes (there maybe more), exempts about 50% of the clearing requirement and 100% of the actual trading requirement on all derivatives.

The bill considers about 11 more amendments and final passage today. To date I can verify loophole #1 is in the final bill, but don't assume you're in the clear. That's simply because it's so complex and massive I haven't read everything yet.

Update: Loophole #2 is in the final bill.

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This just doesn't look good...

I don't know if this has been covered yet, but Sec. 3111, which covers Derivatives Transaction Execution Facilities...

Sections 5a and 5d of the Commodity Exchange Act (7 U.S.C. 7 and 7a-3) are repealed.

I had thought that was the section which fundamentally outlawed speculation and manipulation by credit derivatives?????

reading legislative text is like solving a rat maze puzzle

seriously. Ok, first note that U.S.C. is a different form of the Act, so of course the clause #s are different! (fun, fun!) The U.S.C. version of the Commodity Exchange Act is hosted on the Cornell Web Site (fun, fun, let's make major legislation public only through private law schools!)

and the section 7a-3 is here.

So, the repeal states that no trade board is exempt anymore.

Now on U.S.C. 7, which is here, it looks like this bill redefined which board of trades can deal with derivatives, i.e. contracts so they simply "struck" through this repeal the old legislative text they are replacing.

But this is how it works, one has to sit down with the amendment and go through all of those "strike 2.a.II, part b and put "or;" and then substitute all of that crap into whatever they are amending, which often is located in some law school database, plus you need to make sure you are referencing the right form, so you are looking at the correct bill clause indices, then rewrite the sentence with the new modifications....and then figure out how it now works from the new legislative language.

And folks wonder how corporations are writing the legislation.

That's because no volunteer army can parse these bills fast enough due to this crap the corporate lobbyists pay big bucks for their attorneys to do.

By the time we've traversed the legislative rat maze....they already passed the damn crap into law.

Although this has to wind through the Senate, but I fear an even larger legislative rat maze from the initial Dodd proposal which is massive and then of course in the fine print has exemption after exemption after exemption.

Oops, my mistake...

I was reading 7 U.S.C. 7a, sorry about that.

this is very hard to do

which is why you are seeing hardly anyone, anywhere going through the actual text.

The Frank manager's amendment is loaded with this types of modifications to the original bill language, so there is the one to look at. I fear we have a host of changes and this "permanent bail out" via access to the Fed. window I'm very unsure of. Fine if they want to create a fund only used for dissolution of a firm (well sort of, they should just break them up right now) but if they did create a permanent U.S. taxpayer bail out, I'm not sure. I mean access to U.S. treasury funds of $150 billion is bad enough and that appears to be in there, but do they also have access to Federal Reserve funds? Did Frank give even more power to the Federal Reserve at the last minute, in spite of the committee as well as the House rejecting such an idea of Fed as super regulator?

Of course the real "legislative rat maze" comes in conference, which is beyond the pale. They usually select 6 people, 3 from the House, 3 from the Senate and literally provisions which overwhelmingly passed both houses have been completely changed in conference....

so we've got a long way to go, but from the Senate's track record, odds are it's just going to get much worse.

The Fifth Loophole???

Excellent points, Mr. Oak!

After reading through HR 4173, and the amendments, several times, then sleeping on it and rereading it, I'm going to make the following seemingly farfetched suggestion -- and you may rightfully claim it is nebulous.

After reading Mr. White's intelligent and thoughtful points on those four loopholes (over at seekingalpha) and in conjunction with those four loopholes I believe the fifth loophole is a bit more subtle and more nonobvious or nontrivial: the overall design of this legislation encourages or generates more derivatives market exposure to the S&Ls.

Historically, the S&Ls have had either limited, or the least amount of exposure to the derivatives market. Given the political process trending towards evermore securitization, resecuritization and the creation of further securitized financial products and artificial markets based upon them (e.g., cap-and-trade and those carbon derivatives [Blythe Masters strikes again!], the "public option" and the establishment of insurance exchange(s), concurrent with the explosion in the number of healthcare hedge funds and the push towards mortality derivatives and mortality-linked securities), I would predict this to be yet another effort to further these goals.

Subtle and seemingly nebulous, but I stand by this prediction.

"community banks" loophole, agree its #5

I read that too and it does seem they are exempting them from much of this which to me also is a huge legal loophole for "community banks" to be turned into derivatives trades and take on much more risk.

You think this is bad try figuring out the internal revenue code

following draft and amendment legislation takes a lot of practice. - Financial Information for the Rest of Us.

Roger that!

And that's why those tax attorneys make such big bucks and put Machiavelli to shame....