Wall Street's Derivative Shell Game

Wall Street is now winding their way through the swiss cheese loophole maze financial reform is. Remember credit default swaps, those deadly, bad math, bad computation derivatives which were behind the financial crisis?

Wall street has found a new way to avoid regulation and continue their derivative CDS gambling casino and it is setting up the way for a new financial crisis.  They are re-wrapping credit default swaps and other derivatives into futures, which are exempt from Dodd-Frank. more stringent regulations.

A crucial change in the way financial derivatives are packaged and sold on Wall Street is enabling traders to bypass new regulations aimed at limiting reckless speculation, enhancing the prospect of another derivatives crisis, warn some market participants. 

Under the Dodd-Frank financial reform law adopted by Congress in 2010, investors are required to set aside significant sums of cash to cover losses on their derivatives trades -- money they could otherwise plow into additional investments.  That policy came in response to the financial crisis that began in 2007, when major financial institutions found themselves unable to cover hundreds of billions of dollars in shortfalls on derivatives trades.

But traders have recently forged a path around these so-called margin requirements in order to allow them to harvest larger profits via larger bets:  They are repackaging some derivatives known as swaps into another financial product known as futures.  Futures are less stringently regulated, meaning investors can stake out larger positions while reserving smaller amounts of cash.

Under financial reform, derivative regulation was not done and instead dumped on the CFTC to work out the detals. Of course the lobbyists poured in and now it's a battleground.  Loybbyists have been swarming the CFTC, all to get their derivatives reclassified as futures in order to obtain lower margins and less regulation. 

This all came out in a CFTC round table event, the Futurization of Swaps, which goes into detail on this new whack a mole derivative hiding technique. James Cawley. CEO of Javelin Capital Markets, left this comment:

For one product, the margin calculation is much lower than other, which is correct?  What happens to the clearing house, in the distress scenario, if it becomes evident that not enough margin was collected against the lower margined product?  Does the tax payer now enter the breach to cover the shortfall because DCOs have miscalculated and they been deemed systemically important?

See the issue?  Traders can morph higher regulated derivatives into futures with less oversight and less margin requirements, thus putting the financial system at risk....again.  The requirements and regulation are not enough to stop a house of cards CDS call as we saw with AIG.  This rule was put into place in October and already is raising alarm bells.  The good news, if any, is that alarm bells are ringing at all.  That's the problem with these complex derivatives and massive rules from the CFTC, it's a labyrinth of trading vehicles. But that's the point of derivative regulation, to create a labyrinth so no one can follow and no one can see.

There are many other loopholes being crafted including an offshore outsourced one the CFTC did catch.    CFTC chair Gary Gensler mentioned it in his Senate Banking Committee hearing testimony.

We are hearing, though, that some swap dealers may be promoting to hedge funds an idea to avoid required clearing, at least during an interim period from March until July.  I would be concerned if, in an effort to avoid clearing, swap dealers route to their foreign affiliates trades with hedge funds organized offshore, even though such hedge funds’ principle place of business was in the United States or they are majority owned by U.S. persons.  The CFTC is working to ensure that this idea does not prevail and develop into a practice that leaves the American public at risk. If we don’t address this, the P.O boxes may be offshore, but the risk will flow back here.

The problem is there are thousands and thousands of rules being issued by the CFTC for various types of dervatives.  Like any maze, lawyers are pouring through it all and squeezing through the lines of fine print.



Federal Reserve

One problem with the Wall Street casino is that the Federal Reserve keeps them above water with their low interest rates. Time to cut Wall Street loose to float or sink from their actions.

interest rates not really part of swaps per say

This is more morphing of one type of derivative into another to avoid regulation and less margin requirements. It's akin to 1929 having margin accounts of 95%. People could buy stocks with 5% down and buy on margin, similar risk.

That said, many of these derivatives are completely faulty. The math, the model itself is faulty so why are they even allowed at all?

Do we build bridges with bad math? No, so why is it OK to have really bad financial engineering that puts the system at risk?

Court in D.C. striking down SEC rules right and left

If the SEC manages to set a rule to limit derivatives, it appears there is a favorite court in D.C. which is more than willing to strike it down. Death by a 1000 cuts.

The U.S. Court of Appeals for the D.C. Circuit, located in a little-noticed limestone-and-concrete building situated one block northwest of the Capitol, is where securities rules go to die.