Banks, Exchanges Seek to Influence Derivatives Reform

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Derivatives trading as featured in the 1983 movie "Trading Places."

The final piece of the financial regulatory reform puzzle is about to come into place as Sen. Blanche Lincoln released language last Friday that would impose rules on the unregulated world of over-the-counter derivatives trading. Lincoln’s bill, the Wall Street Transparency and Accountability Act, is more far reaching than proposals from both the Obama administration and the House of Representatives. This comes as somewhat of a surprise from the moderate and previously bank-friendly senator who has benefited from finance industry contributions in her post as chair of the Senate Agriculture Committee.

The Agriculture Committee occupies a unique place in the oversight of the nation’s financial markets. With legislative jurisdiction over the Commodity Futures Trading Commission (CFTC)–historically futures trading began as a trading mechanism for farmers–the committee maintains jurisdiction over futures and derivatives trading. This unique arrangement provides committee members the ability to pull campaign contributions from the most prolific giver of contributions, the financial sector.

What are derivatives?
Examples from the financial meltdown
How did some derivatives escape regulation?

In 2009, Lincoln raised $693,500 from the finance, insurance and real estate sector, according to data obtained from the Center for Responsive Politics. Those with a specific stake in derivatives reform did not begin contributing to her campaign until she ascended to the chairmanship of the committee after the death of Sen. Edward Kennedy caused a a shuffling of committee seats. Since ascending to the Agriculture Committee chair Lincoln raised $256,900 from the finance, insurance and real estate sector. She also raised over $44,000 from financial companies with a major stake in derivatives reform–almost twice as much as she raised in the previous eight months from similar companies.

In total these major derivatives players contributed approximately $70,000 to Lincoln’s reelection campaign. These companies include fifteen members of the International Swaps and Derivatives Association (ISDA), an international trade association that writes the rules for derivatives trading that remains unregulated. Some of these contributors include  JPMorgan Chase, Goldman Sachs, Bank of America, Credit Suisse, Deutsche Bank and UBS.

Despite all of the money and lobbying power—Credit Suisse employs Lincoln’s former chief of staff as a lobbyist—expended to deflect new regulations, Lincoln has unveiled unexpectedly tough regulations. (Click here to see Lincoln’s reforms.) While these tougher rules will set up a fight in the Senate, they will assuredly create a massive industry showdown if they pass the Senate and move to conference with the House to reconcile the two bills.

Finance influence in the House

Unlike Lincoln’s bill, which goes against the wishes of her financial sector fundraisers, the House bill is a reflection of the finance sector’s enduring influence in Washington. Throughout the process, the derivatives section of the House bill was consistently amended in favor to the finance industry as efforts to toughen the bill were defeated.

The Obama administration has argued that the majority of over-the-counter derivatives be traded out in the open on exchanges or cleared through clearinghouses. The banks and others have argued for broad exemptions for which over-the-counter derivatives would be required to be traded in the open. The House bill, however, wound up riddled with exemptions.

The bill began under the control of Rep. Barney Frank, the chairman of the House Financial Services Committee. The Financial Services Committee is a cherished post for congressmen to raise money and for staffers to gain knowledge for a future lobbying job. Since 2000, nearly half of the 126 committee staff who left the committee became lobbyists, according to a report by The Huffington Post. The committee is also the chief conduit for financial sector campaign contributions with the 71 committee members, or 16% of the 435 member body of Congress, accounting for 33% of all financial sector campaign contributions to members of the House in 2009.

In October 2009, Bloomberg reported on the crucial role that members of the New Democrat caucus played in helping add exemptions and loosening regulations on over-the-counter derivatives. Many of these members, along with their ideological counterparts, the Blue Dog Democrats, received inordinate amounts of campaign contributions from the financial sector.

Financial Services Committee member Gregory Meeks pulled in over 50% of his 2009 campaign contributions from the financial sector. Rep. Melissa Bean, another committee New Dem, raked in over 47% of her contributions from the financial sector, as did Rep. Dennis Moore. Committee members Jime Himes and David Scott pulled in over 30% of their campaign haul from finance companies and Rep. Charlie Wilson and Ron Klein pulled in over 25% of their total contributions from finance.

A major point of contention is what kinds of exemptions should exist for the over-the-counter derivatives that will be pushed onto exchanges and into clearinghouses. Both the Financial Services Committee and the House Agriculture Committee carved out large exemptions for “end-users”–a wide-swath of companies that may include mutual funds, insurance companies, hedge funds and private-equity capital. The exemptions also aid the top five banks in the United States—Citi, JPMorgan Chase, Bank of America, Morgan Stanley and Goldman Sachs—which hold approximately 95% of the over-the-counter derivatives exposure among the top 25 banks, according to the Comptroller of the Currency.

CFTC Chairman Gary Gensler, speaking on behalf of the Obama administration, declared the exemptions in the House bill unacceptable, adding, “we should ensure that every transaction between Wall Street banks and their financial customers, such as hedge funds, insurance companies or leasing companies, be subject to a clearing requirement.”

The loosening of the derivatives language continued when the bill hit the floor. An amendment widening the “end-user” exemption offered by Rep. Scott Murphy, a recipient of $525,015 in campaign contributions from the financial sector in 2009, passed by a wide margin with 131 Democrats in support—87 of them were New Dems or Blue Dogs. The House also voted down three amendments that would have placed tougher regulations on derivatives trading. The regulations that would have been imposed by these three defeated amendments mirror regulations proposed by Sen. Lincoln in her derivatives reform bill.

A lot of industry players came away from the House debate moderately contented. The coming showdown between the House and Senate over derivatives will reignite their engines and push them to pressure their allies in the House. One industry, specifically one company, will emerge from this debate with a windfall in profits, no matter which version of the bill passes.

Clearing and exchange trading requirements

Intercontinental Exchange, Inc. (ICE) operates derivatives exchanges and owns the biggest over-the-counter derivatives clearinghouses in the country. (See here for an explanation of exchanges and clearinghouses.) Both the House bill and Lincoln’s bill would increase the number and type of derivatives that would be required to be cleared by a clearinghouse like the one ICE operates. The House bill has a series of exemptions and loopholes governing clearing and reporting, while the Lincoln proposal contains a strict requirement for clearing. Either way, this will pump up ICE’s bottom line. It also would be a boon for the big banks as well.

In 2008, ICE purchased The Clearing Corporation, an over-the-counter derivatives clearinghouse from its owners. The owners included a who’s who of major banks including JPMorgan Chase, Goldman Sachs, Bank of America, Citi and Morgan Stanley. ICE turned The Clearing Corporation into ICE Trust, which in March of 2009 became the first clearinghouse approved by the Securities and Exchange Commission (SEC) to begin clearing over-the-counter derivatives. If over-the-counter derivatives have to go onto an exchange, there is little option outside of ICE Trust.

When ICE purchased The Clearing Corporation they entered into a detailed profit sharing agreement with their partners, the big banks. The banks and ICE have a 50-50 profit sharing agreement for all profits that come from trades that are cleared by ICE Trust. As previously mentioned, these big banks account for over 90% of the over-the-counter derivatives market. A requirement, especially with a series of exemptions that the banks can take advantage of themselves, would increase profits for both ICE and the big banks. In the nine months that ICE Trust was open for business it processed $3.1 billion in trades and received $30 million in fees.

In testimony before Sen. Lincoln’s committee in December, ICE general counsel Johnathan Short stated ICE’s support for an increase in transparency in the market, but also voiced opposition to a requirement that all over-the-counter derivatives trades be cleared or be made over an exchange, much in line with the position of the big banks.

The big banks have an incentive to create as many exemptions in the clearing and exchange trading requirement as possible.This may seem counter-intuitive as ICE would benefit handsomely if all trades had to be processed by their clearinghouse for a fee. But it would not benefit the big banks who are partners with ICE in ICE Trust. The big banks have an incentive to create as many exemptions in the clearing and exchange trading requirement as possible. Previously, if an airline or a manufacturer wanted to purchase a derivatives contract they had to do it through a big bank, as the big banks had good credit ratings and were seen as a safe place to make these trades. This allowed the big banks to charge both the user and the trader fees for making the contract. If all derivatives contracts are required to be traded on exchanges or cleared then the users and traders could simply make contracts with each other rather than relying on a bank as a go-between. With a wide-range of exemptions to clearing and exchange trading, derivatives contracts could still be made within the big banks and then contracts made by big banks could cleared through a clearinghouse like ICE Trust.

Over the past three years, ICE increased its lobbying operation in Washington. Last year, ICE spent nearly $700,000 to lobby Congress and the executive branch. In their pursuit of lobbying talent, ICE poached a top member of the House Financial Services Committee staff, Peter Roberson. ICE picked well. Roberson had a hand in crafting the House bill’s derivatives language, including its many exemptions. Roberson’s job switch infuriated his former boss Barney Frank, who subsequently banned committee staff from talking to Roberson while he remains chairman of the committee.

ICE’s campaign contributions increased as well. Sen. Lincoln was the recipient of $12,300 in campaign contributions from ICE’s employees and political action committee. The only member of Congress to receive more in 2009 is Banking Committee Chairman Chris Dodd, who is no longer running for reelection.

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  • John Wright

    On 04/23/10 Patricia from Bank of America called me. She said she could not speak to me because I am in litigation with BofA. Apparently, she is a CEO and really high up there. You should call her and ask her about your modifications and say “I support the John Wright Vs. Bank of America Lawsuit.” The number she called from was: 818-713-2886.

    The Yahoo address above stopped working for the article on my story. You may use this link to read about it:

    Lawsuit Posted http://www.unitedlawgroup.com or:
    http://www.prweb.com/releases/2010/03/prweb3766544.htm

  • John Wright

    If it walks like a piggy, talks like a piggy, by golly it’s a PIGGY!

    BofA and it’s CEO Brian Moynihan reminds me of that song by John Lennon and George Harrison titled “Piggies” I invite you to listen to this song on youtube and see if it appropriately fits.

    http://www.youtube.com/watch?v=NTmeHM-Hojg&feature=related

    Have you seen the little piggies
    Crawling in the dirt
    And for all the little piggies
    Life is getting worse
    Always having dirt to play around in.

    Have you seen the bigger piggies
    In their starched white shirts
    You will find the bigger piggies
    Stirring up the dirt
    Always have clean shirts to play around in.

    In their ties with all their backing
    They don’t care what goes on around
    In their eyes there’s something lacking
    What they need’s a damn good whacking.

    Everywhere there’s lots of piggies
    Living piggy lives
    You can see them out for dinner
    With their piggy wives
    Clutching forks and knives to eat their bacon.

    John Wright vs. Bank of America Lawsuit at:

    http://news.yahoo.com/s/prweb/20100323/bs_prweb/prweb3766544_1

    When I filed my lawsuit against Bank of America, myself and United Law Group thought of the many others out there in the same situation. It was then that we decided to educate the public on what these piggy banks are doing, as well as unite us all together as one voice. Please help me turn this David vs. Goliath modification process, into a Goliath vs. Goliath.

    Please stand with me and United Law Group and send an email to Bank of America that states that we will no longer tolerate their potentially illegal, fraudulent, irregular and abusive business methods.

    Divided we might have fell America, but united we must stand!

    Please send your email directly to Bank of America and include the following:

    1. Your name
    2. Your complaint concerning your experience with Bank of America.
    3. Please end your email “I support John Wright vs. BofA Lawsuit!”
    4. Please send a copy of your email to johns-wright@hotmail.com
    5. Please send your email to both BofA link below and the CEO email

    BofA Linked Email:
    https://www3.bankofamerica.com/contact/?lob=general&contact_returnto=&state=VA

    CEO Brian Moynihan:
    brian.t.moynihan@bankofamerica.com

    Matthew Task, Executive Relations
    Office of the CEO
    813-805-4873

  • Examples from the financial meltdown:

    1)Lehman Brothers: Lehman Brothers was deeply involved in the over-the-counter derivatives market prior to their 2008 collapse. The investment company used money provided as collateral from one firm it had entered into a derivatives contract with to fund trades with other firms. In total, when the company collapsed it had entered into contracts with around 8,000 different firms and could not pay back much of the collateral as it had been used to place other bets.

    2)American International Group (A.I.G.): A.I.G. was the biggest insurance company on the block until the collapse in home mortgage value revealed a practice where the company backed its insurance contracts with derivatives contracts whose sole value was based on home mortgage prices and other commodities. The company was bailed out by the U.S. government, which helped pay off the insurance contracts that A.I.G. had entered into with many large banks.

    3)Fannie Mae/Freddie Mac: Much like A.I.G., Fannie Mae and Freddie Mac were using derivatives contracts to back the home mortgages that they offered. When the prices in mortgages collapsed, so too did the balance sheets for two home mortgage lending giants. Fannie and Freddie were both taken over by the government and given an unlimited line of credit to pay off the partners in their now-defaulted derivatives trading business.

    4)Goldman Sachs: Goldman Sachs is one of the biggest derivatives traders in the market. According to both newspaper accounts and a civil complaint filed by the Securities and Exchange Commission (SEC), starting in 2006, traders at the company entered into bond deals that were backed by derivatives contracts on home mortgages while at the same time betting against those same derivatives contracts. Goldman Sachs is currently facing a civil complaint from the government based on these charges.

  • Derivatives are a financial product that consists of a contract between two parties that derives its value from another product or financial instrument. Derivatives contracts may be based on conditions that may relate to the price fluctuation of a particular product like fuel, corn, pork bellies, currencies or home mortgages. Derivatives are commonly traded as a type of insurance to protect against risk, both seen and unforeseen. In recent years, derivatives have been used in a much more speculative capacity with banks placing large bets on whether prices will rise or fall in a particular market. The meltdown in the financial industry was largely a result of banks placing speculative bets on home mortgages.

    Much of the speculative derivatives trading occurs through the over-the-counter derivatives market. Instead of trading openly through an exchange or cleared on a clearinghouse, over-the-counter derivatives are traded behind closed doors between two parties. The major players in the over-the-counter derivatives market include the major banks, hedge funds and insurance companies. The global over-the-counter derivatives market is the largest portion of the overall derivatives market and is estimated to be at a total notional amount of over $600 trillion.