OTC Derivatives market Reform
Henry C.K. Liu

Part I: The Folly of Deregulation


Part II: The Courageous Brooksley Born
In 2009, the John F. Kennedy Profile in Courage Award, the nation’s most prestigious honor for elected public servants, was given to Brooksley Born for her role in 1998, as chair of the Commodity Futures Trading Commission (CFTC), to try, albeit unsuccessfully, to bring OTC (over the counter) financial derivatives under the regulatory control of the CFTC weeks before the collapse of hedge fund Long Term Capital Management (LTCM).
OTC derivatives are contracts executed outside of the regulated exchange environment whose value depends on (or derives from) the value of an underlying asset, reference rate or index. Market participants use these instruments to perform a wide variety of useful risk management functions. The Bank of International Settlement (BIS) reports the notional value of outstanding OTC derivatives contracts ending June 2009 to be $49.2 trillion worldwide against a 2009 world GDP of $65.6 trillion.
The award citation read: “The government’s failure to regulate such financial deals has been widely criticized as one of the causes of the current financial crisis. In the booming economic climate of the 1990’s, Born battled other regulators in the Clinton Administration, skeptical members of Congress and lobbyists over the regulation of derivatives, warning that unregulated financial contracts such as credit default swaps could pose grave dangers to the economy. Her efforts brought fierce opposition from Wall Street and from Administration officials who believed deregulation was essential to the extraordinary economic growth that was then in full bloom. Her adversaries eventually passed legislation prohibiting the CFTC from any oversight of financial derivatives during her term. She stepped down from the CFTC in 1999 and returned to a distinguished career in public interest law.”
Born, an attorney, was nominated as CFTC chair by President Clinton on May 3, 1996, and confirmed by the Senate on August 2, 1996, to a term expiring April 15, 1999 and stayed on to serve as acting chair until she resigned on June 1, 1999.
At CFTC, Brooksley Born conducted a financial analysis which led her to anticipate a serious financial crisis due to growth in the trade of unregulated derivatives. Born was particularly concerned about swaps, financial instruments that are traded over-the-counter on the dark market (trading on a cross network an Alternative Trading System (ATS) that matches buy and sell orders electronically for execution without first routing the order to an exchange or other displayed markets, such as an Electronic Communication Network (ECN), which displays a public quote. Instead, the order is either anonymously placed into a black box or flagged to other participants of the crossing network. The advantage of the crossing network to the transaction parties is the ability to execute a large block order without impacting the public quote. Swaps thus have no transparency except to the two counter-parties. The disadvantage to the market is that material information is hidden from market participants.
On May 7, 1998, the CFTC under Brooksley Born issued a “Concept Release Concerning OTC Derivatives Market” requesting comments on whether the OTC derivatives market was properly regulated under the existing exemptions of the Commodity Exchange Act (CEA), a federal act passed during the New Deal era in 1936, and on whether market developments required regulatory changes.
Greenspan, Rubin, Summers and Levitt Opposed Regulation
Financial regulation, even against fraud, was strenuously opposed by Federal Reserve chairman Alan Greenspan, Treasury Secretary Robert Rubin and Undersecretary Larry Summers, who is now the top economic policymaker in the Obama White House. On May 7, 1998, SEC Chairman Arthur Levitt joined Rubin and Greenspan in objecting to the issuance of the CFTC’s Concept Release. Their response off-handedly dismissed Born’s concerns on inadequate regulation on the ground that discussing the regulation of swaps and other OTC derivative instruments would increase legal uncertainty of such instruments, potentially creating turmoil in the already adequately self-regulated markets, and reducing the market value of these instruments. Further concerns voiced were that the imposition of new regulatory constraints would stifle innovation and push coveted transactions offshore through cross-border regulatory arbitrage.
In the Senate Agriculture Committee hearing on July 30, 1998, Chairman Richard G. Lugar, Indiana Republican, attempted to extract a public promise from Born to cease her campaign for regulation on the OTC derivative market in exchange for warding off a move in Congress for a Treasury-backed bill to slap a moratorium on further CFTC action.
To her credit, Born stood her ground, portraying her agency as being under attack for carrying out its statutory mandate by anti-regulation agencies, namely, the Fed, the Treasury and the SEC. Fed chairman Greenspan shot back angrily that CFTC regulation was superfluous, and that existing laws were quite adequate. “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary,” Greenspan said, referring to OTC derivatives, adding, “Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living.” 
According to Greenspan et al, the market can police itself even against fraud because it is run by honorable people who have strong incentives to protect the market from fraud. But the issue at the hearing was more than bureaucratic turf war. It was an ideological battle with the full power of the Federal government siding with Wall Street to suppress the dutiful carrying out of the statutory mandate of a small agency to protect the general public. Born was effectively silenced by a concerted effort by top officials in the Clinton administration after she responded to a challenge from a Committee member on what she was trying to protect by saying: “We’re trying to protect the money of American public.”
Larry Summers then as Treasury Undersecretary, now top economic policymaker in the Obama administration, was reportedly the Clinton administration’s hatchet man to shut up Born and shut down CFTC demand for regulation of the OTC derivatives market. Born resigned as head of CFTC on June 1, 1999 in frustration.
After the global financial crisis of 2008, Greenspan has since publicly confessed to Congress that he had erred in his judgment on the self regulating power of the market. It is not known if he has apologized to Ms Born personally privately.
An October 2009 Public Broadcasting System “Frontline” documentary titled: “The Warning” described Born’s failed efforts to regulate and bring transparency to the secretive derivatives market, and noted the continuing resistance to reform. The program concluded with Born sounding another warning: “I think we will have continuing danger from these markets and that we will have repeats of the financial crisis -- may differ in details but there will be significant financial downturns and disasters attributed to this regulatory gap, over and over, until we learn from experience”
Wendy and Phil Gramm
Before Brooksley Born, Wendy Gramm served as chair of CFTC from 1988 to 1993. Gramm is an economist and the wife of influential Republican Senator Phil Gramm of Texas.  Responding to an intense lobbying campaign from Enron, the CFTC under Gramm exempted the energy trading company from regulation on energy derivatives trading which contributed to the eventual collapse and bankruptcy of the company in November 2001.
Wendy Gramm resigned from the CFTC in 1993 to accept a seat on the Enron Board of Directors and to serve on its Audit Committee for which she received $1.86 million. While on the Enron Board, she received donations from Enron to support the Mercatus Center at the conservative George Mason University on “market-oriented research, education, and outreach think tanks that work with policy experts, lobbyists, and government officials to connect academic learning and real-world practice.”
The Mercatus Center was founded by Rich Fink, former president of the Koch Foundation, the philanthropic arm of Koch Industry, a private corporation based in Wichita, Kansas with subsidiaries involved in core industries such as commodities trading, petroleum, chemicals, energy, fiber, intermediates and polymers, minerals, fertilizers, pulp and paper, chemical technology equipment, ranching, securities and finance, as well as in other ventures and investments. In 2008, it was the second largest privately held company in the United States (after Cargill) with annual revenue of about $98 billion.
In 2001, the Office of Management and Budget (OMB) of the Bush White House asked for public input on which Federal regulations should be revised or suspended. Mercatus submitted 44 of the 71 proposals the OMB received. The recommendations from Mercatus attacked Federal regulations such as a proposed Interior Department rule prohibiting snowmobiles in Rocky Mountain National Park, a Transportation Department rule limiting truckers’ consecutive hours behind the wheel without a rest, and a US Environmental Protection Agency rule limiting the amount of arsenic in drinking water, not because these regulations are bad for society, but that ideologically, Mercatus believes such protection should not be imposed by government and that the people should have the right to chose for themselves whether they want to drink poisoned water.
The President’s Working Group
The President’s Working Group on Financial Markets (PWG), dubbed by a Washington Post headline as Plunge Protection Team, was created by Executive order 12631 signed on March 18, 1988 by President Ronald Reagan after the financial crisis of 1987 to give recommendations for legislative and private sector solutions for “enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence.” PWG is chaired by the Secretary of the Treasury, or his designee; and members are the Chairman of the Board of Governors of the Federal Reserve System, or his designee; the Chairman of the Security and Exchange Commission, or his designee; and the Chairman of the Commodity Futures Trading Commission, or his designee.  Born was a PWG member by virtue of her position as chair of CFTC.
In April 1999, the PWG issued a report on the lessons of the pending collapse of Long-Term Capital Management (LTCM)  in May 1998 and six months after the subsequent bailout of LTCM by creditors arranged by the New York Fed on September 23, 1998. It was Born’s last participation in the PWG before reigning two months later on June 1. The report raised some alarm over excess leverage and the opaque risks of the OTC derivatives market, but called for only one legislative change -- a recommendation that unregulated affiliates of brokerages be required to assess and report their financial risk to government regulators.  Fed Chairman Greenspan dissented even on that vague recommendation on the ground that self regulation was preferred.
Lessons of LTCM
Five months after the CFTC issued its Concept Release, CFTC chairperson Brooksley Born gave a talk on October 15, 1998, entitled: the Lessons of Long-term Capital Management at the Chicago Kent-IIT Commodity Law Institute in which she said: “The events surrounding the financial difficulties of Long-Term Capital Management L.P. ("LTCM") raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and other institutions in the global financial markets. Most of these issues were raised by the Commission in its Concept Release on OTC Derivatives in May 1998. They include lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators.”

On the lack of transparency Born said: “While the CFTC and the US futures exchanges had full and accurate information about LTCM’s exchange-traded futures positions through the CFTC’s required large position reports, no federal regulator received reports from LTCM on its OTC derivatives positions. Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives users and about the nature and extent of their exposures potentially allows OTC derivatives market participants to take positions that may threaten our regulated markets or, indeed, our economy without the knowledge of any federal regulatory authority.”

There are no requirements that a hedge fund like LTCM must provide disclosure documents to its counterparties or investors concerning its positions, exposures, or investment strategies. Even LTCM’s major creditors did not have a complete picture of LTCM’s financial health. A hedge fund’s derivatives transactions have traditionally been treated as off-balance sheet transactions. Therefore, even though some hedge funds like LTCM are registered with the Commission as commodity pool operators and are required to file annual financial reports with the Commission, those reports do not fully reveal their OTC derivatives positions.

Unlike futures exchanges where bids and offers are quoted publicly, the OTC derivatives market has little price transparency. Lack of price transparency may aggravate problems arising from volatile markets because traders may be unable accurately to judge the value of their positions or the amount owed to them by their counterparties. Lack of price transparency also may contribute to fraud and sales practice abuses, allowing OTC derivatives market participants to be misled as to the value of their interests.

Transparency is one of the hallmarks of exchange-based derivatives trading in the US. Recordkeeping, reporting, and disclosure requirements are established by the Commodity Exchange Act and the Commission’s regulations; prices are discovered openly and competitively; and quotes are disseminated instantaneously. Positions in exchange-traded contracts are marked-to-market at least daily, thus ensuring that customers are always aware of the profit or loss on their positions. This transparency significantly contributes to the fact that US futures markets are the most trusted in the world.

A report in 1998 by the G-22 group of industrialized and developing nations called for improved transparency in both the public and private sectors, including an examination of the feasibility of compiling and publishing data on the international exposures of investment banks, hedge funds and other large institutional traders. Born maintained that, “If reporting and disclosure requirements had been in place in the US, some of the difficulties relating to LTCM might have been averted.”

On the issue of excessive leverage, Born observed that “While traders on futures exchanges must post margin and have their positions marked to market on at least a daily basis, no such requirements exist in the OTC derivatives market.”
LTCM managed to borrow approximately 100 times its capital and to hold derivatives positions with a notional value of approximately $1.25 trillion ­or 1000 times its capital. Indeed, it has been reported that LTCM generally insisted that it would not provide OTC derivatives counterparties with initial margin. LTCM's swap counterparties and other creditors reportedly did not have full information about its extensive borrowings from others and therefore unknowingly extended enormous credit to it.
Born warned that “This unlimited borrowing in the OTC derivatives market, ­like the unlimited borrowing on securities that contributed to the Great Depression,­ may pose grave dangers to our economy.”

The CFTC Concept Release on OTC Derivatives describes many of the risk-limiting mechanisms of the futures exchanges ­ including mutualized clearing arrangements, marking to market, margin requirements, and capital and audit requirements. The Concept Release requests comment on whether similar protections are needed in the OTC derivatives market. Some market participants have already answered in the affirmative. Born suggested that “Clearing of OTC derivatives transactions could be a useful vehicle for imposing controls on excessive extensions of credit. It is essential for federal financial regulators to consider how to reduce the high level of leverage in the OTC derivatives market and its attendant risks.”

Insufficiency of the internal controls applied by the LTCM itself and its lenders and counterparties was another critical issue. The CFTC Concept Release on OTC Derivatives calls for comment on a number of issues relating to the sufficiency of internal controls and risk management mechanisms employed by OTC derivatives market participants, including value-at-risk (VaR) models. LTCM now stands as a cautionary tale of the fallibility of even the most sophisticated VaR models. The prudential controls of LTCM’s OTC counterparties and creditors, the parties that presumably had the greatest self-interest in assessing LTCM’s financial wherewithal, also appeared to have failed. They were reportedly unaware of the fund’s extensive borrowings and risk exposures. US financial regulators urgently need to address these failures.

International regulators have expressed concern for some time about the lack of effective oversight of hedge funds and other large users of OTC derivatives and their ability to avoid regulation by any one nation in their global operations. Indeed, several emerging market countries have attributed crises in their currencies and markets to the actions of large hedge funds. The LTCM situation presents a new opportunity for CFTC and other US regulators to work with authorities in other countries to harmonize regulation of the OTC derivatives market and to implement international regulatory standards.
G22 Report
The 1998 report by the G-22 was an important step in this direction and demonstrated a growing international consensus regarding the need for increased transparency. A study by the G-22 of how to implement reporting requirements was to proceed more or less in parallel with the President’s Working Group study on the regulatory implications of the LTCM episode. Important work by the International Organization of Securities Commissions (IOSCO) on the need for transparency and large position reporting related to exchange-traded derivatives was considered as useful to the G-22 study and the President’s Working Group study on OTC derivatives.
Born concluded that “there is an immediate and pressing need to address possible regulatory protections in the OTC derivatives market. The LTCM episode not only has demonstrated the potential risks posed by the OTC derivatives market for the domestic and global economy, but also has highlighted the importance of the safeguards in place for exchange-traded futures and options. Obviously, regulation must be adapted to the particular marketplace and must address the risks to the public interest that that market poses. Thus, regulatory solutions for exchanges are not necessarily appropriate for the OTC market. Nonetheless, the markets involve similar instruments and pose many of the same risks, and our successful experience with the US futures exchanges will be invaluable in the study of the OTC derivatives market.”
Congress Overruled CFTC on Regulation
In March 1999, Congress passed a law preventing the CFTC from changing its treatment of OTC derivatives. CFTC chair Born lost control of the issue at the CFTC when three of her four fellow Commissioners announced they supported the legislation and would temporarily not vote to take any action concerning OTC derivatives. Thus defeated, CFTC chair Born resigned effective June 1, 1999. Her successor, William Rainer, was CFTC chair when the PWG Report was issued in November 1999.
Less than a decade later, with no regulatory reform accomplished since the LTCM collapse in 1998, a global financial crisis broke out in 2007.
In November 1999, Greenspan, Rubin, Levitt and Born’s replacement at CFTC, William Rainer, submitted a President’s Working Group report on derivatives. They recommended no CFTC regulation, saying that it “would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States.”
Clinton Signed Gramm-Leach-Bailey Act to Repeal Glass-Steagall
On November 12, 1999, a lame duck President Clinton signed into law the Gramm-Leach-Bailey Financial Services Modernization Act (GLBA) which repealed the Glass-Steagall Act of 1933, the New Deal era legislation designed to control financial speculation. GLBA reverses the Glass-Steagall separation of commercial and investment banks and allows them to re-consolidate. The repeal of the Glass-Steagall Act, by combining the conflicting roles of lending institutions and security issuing institutions, facilitated the development of structured finance and debt securitization that contributed structurally to the 2007 credit crisis.

Phil Gramm, who began his political career as a Democratic congressman in the Texas populist tradition, changed party affiliation to become a neo-liberal Republican senator from Texas. As Republican chairman and ranking member of the Senate Banking Committee, he spearheaded the Gramm-Leach-Bailey Act of 1999 with the ideological conviction that higher bank profits commensurate with higher risk were the salvation of the US economy operating on the myth of market fundamentalism, reversing the age-old principle that banks as intermediary of money should be the economy’s most risk-averse institutions.

Between 1995 and 2000, Phil Gramm received more than $1 million in campaign contribution from the securities and investment industry, more than he received from oil and gas interests that traditionally were a key source of financial energy in Texas politics. After retiring from politics in 2002, Gramm became vice-chairman of the investment banking arm of Union Bank of Switzerland (UBS), an institution by 2007 was in the spotlight for massive losses from subprime mortgage exposure. Gramm was an economic adviser to the presidential campaign of Republican candidate John McCain in 2007 and was dropped after he characterized the breaking financial crisis as merely an illusion of the whining public’s “mental depression”.
After the Enron scandal broke open in October 2001, Wendy Gramm and the other Enron directors were named in several investor lawsuits, most of which have since been settled. In particular, Wendy Gramm and other Enron directors had to agree to a $168 million dollar settlement in a law suit led by the University of California, whose pension fund invested in Enron stocks that had lost all value from fraudulent transactions in OTC derivatives when Enron filed bankruptcy protection.
UC led a shareholder class action suit against Enron and its banks, alleging that internal Enron documents and testimony of bank employees detailed how the banks engineered sham transactions to keep billions of dollars of debt off Enron’s balance sheet to create the illusion of impressive earnings and operating cash flow. As part of that settlement, Enron directors agreed to collectively pay $13 million to settle charges of insider trading. The remainder of the settlement was to be paid by the company’s liability insurance.
The Gramm-Leach-Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999, by repealing parts of the Glass–Steagall Act of 1933, opened up financial markets to merged entities of banking companies, securities companies and insurance companies. The Glass–Steagall Act had prohibited any one institution from acting as any combination of investment banking, commercial banking, security firms and/or an insurance underwriting.
GLBA allowed commercial banks, investment banks, securities firms and insurance companies to reconsolidate vertically. An example was the merger of Citicorp (a commercial bank holding company) with Travelers Group (an insurance company) and the acquisition of Smith Barney (a brokerage) in 1998 to form the financial conglomerate Citigroup, a corporation combining banking, securities and insurance services under a house of brands that included Citibank, Smith Barney, Primerica and Travelers. This combination, announced in 1993 and finalized in 1994, would have violated the Glass–Steagall Act of 1933 and the Bank Holding Company Act of 1956 that forbade combining securities, insurance, and banking, if it were not for a temporary waiver process. GLBA legalizes these mergers on a permanent basis.
President Obama has publicly expressed his belief that the GLBA directly helped cause the 2007 subprime mortgage financial crisis. Many economists have also criticized GLBA for not only having contributing to the 2007 crisis, but also under the present monetary system of fiat currency, GLBA promotes corporate welfare for financial institutions that are deemed “too big to fail” and a moral hazard that cost innocent taxpayers heavily. Nobel laureate economist Paul Krugman called Senator Phil Gramm, lead sponsor of GLBA, “the father of the [2007] financial crisis”. Nobel laureate economist Joseph Stiglitz also argued that GLBA helped to create the financial crisis of 2007.
In response to criticism of his signing the GLBA as president, Bill Clinton said in 2008:
“I don't see that signing that bill had anything to do with the current crisis. Indeed, one of the things that has helped stabilize the current situation as much as it has is the purchase of Merrill Lynch by Bank of America, which was much smoother than it would have been if I hadn’t signed that bill.... On the Glass–Steagall thing, like I said, if you could demonstrate to me that it was a mistake, I'd be glad to look at the evidence.”
In February 2009, Senator Phil Gramm, wrote in defense of GLBA that: “...if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass–Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified. … Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a super regulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.”
Neoliberal economist Brad DeLong of the University of California, Berkeley, who was Deputy Assistant Treasury Secretary under Larry Summers in the last months of the Clinton Administration, and conservative economist Tyler Cowen of George Mason University in Virginia and a director of Mercatus Center, both argue, albeit from opposing ends of the ideological spectrum, that the GLBA softened the impact of the financial crisis, notwithstanding the fact that GLBA contributed to the emergence of the financial crisis in the first place. An article in conservative National Review labeled liberal allegations about the GLBA causing the financial crisis “folk economics” which one assumes was intended as an elitist derogatory dismissal of populism for its lack of intellectual rigor.
In an interview on November 10, 2009 with The Daily Deal, H. Rodgin Cohen, chairman of Sullivan & Cromwell, a law firm intimately involved with the repeal of Glass-Steagall, characterized blaming the repeal of certain provisions of the Glass-Steagall Act for the 2008 economic crisis as a myth. “Lehman, Bear Stearns, the GSEs, Washington Mutual, and Wachovia [had nothing to do with the repeal of Glass-Steagall],” Cohen said, adding, “Much of the problem was the unregulated mortgage bankers and brokers, who ultimately polluted the system.”
Commodity Futures Modernization Act
Throughout much of 2000, lobbyists for the OTC derivative industry were flying in and out of congressional offices. With Born gone from CFTC since June 1, 1999, they saw an opportunity to finally bury the regulatory issue. They had a sympathetic ear in Texas Senator Phil Gramm, the influential Republican chairman of the Senate Banking Committee, whose wife later became chairperson of the CFTC. A sympathetic Senator Gramm sheparded a deregulation bill: the 2000 Commodity Futures Modernization Act (CFMA).
CFTC Chairperson Wendy Gramm’s husband, Senator Phil Gramm, lead sponsor of GLBA in 1999, was also one of five co-sponsors of the Commodity Future Modernization Act of 2000 (CFMA), going beyond the recommendations of a Presidential Working Group on Financial Markets Report titled “Over-the-Counter Derivatives and the Commodity Exchange Act” (PWG Report), which was requested by the House and Senate Agriculture Committee chairmen in September 1998 and presented to the committee in November 1999. The committee’s request for the PWG was “to conduct a study concerning the OTC derivatives market and provide legislative recommendations to Congress regarding whether these markets require additional regulation.”
OTC Derivatives Regulation before the CFMA
The PWG Report of 1999 was directed at ending controversy over how swaps and other OTC derivatives related to the Commodity Exchange Act (CEA), a federal act passed during the New Deal era in 1936, replacing the Grain Futures Act of 1922.
CEA provided federal regulation of all commodities and futures trading activities and required all futures and commodity options to be traded on organized exchanges. In 1982, CEA created the National Futures Association (NFA), an independent self-regulatory organization and watchdog of the commodities and futures industry. The NFA oversees and protects investors from fraudulent commodities and futures activities and provides mediation and arbitration for resolving consumer complaints. NFA is headquartered in Chicago with an office in New York City. Its establishment represented a rising trend in favor of industry self regulation over government regulation.
Before 1974, the CEA was applicable only to agricultural commodities. “Future delivery” contracts in agricultural commodities listed in the CEA were required to be traded on regulated exchanges such as the Chicago Board of Trade.
The Commodity Futures Trading Commission Act of 1974 created the Commodity Futures Trading Commission (CFTC) as the new government regulator of commodity exchanges. It also expanded the scope of the CEA to cover the previously listed agricultural products and “all other goods and articles, except onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.” Existing non-exchange traded financial “commodity” derivatives markets (mostly “interbank” markets) in foreign currencies, government securities, and other specified instruments were excluded from the CEA through the “Treasury Amendment”, to the extent transactions in such markets remained off a “board of trade.” The expanded CEA, however, did not generally exclude financial derivatives.
After the 1974 law change, the CEA continued to require that all “future delivery” contracts in commodities covered by the law be executed on a regulated exchange. This meant any “future delivery” contract entered into by parties off a regulated exchange would be illegal and unenforceable. The term “future delivery” was not defined in the CEA. Its definition evolved through CFTC actions and court rulings.
Not all derivative contracts are “future delivery” contracts. The CEA always excluded “forward delivery” contracts under which a farmer might set today the price at which the farmer would deliver to a grain elevator or other buyer a certain number of bushels of wheat to be harvested next summer. By the early 1980s, a market in interest rate and currency “swaps” had emerged in which banks and their customers would typically agree to exchange interest or currency amounts based on one party paying a fixed interest rate amount (or an amount in a specified currency) and the other paying a floating interest rate amount (or an amount in a different currency). These transactions were similar to “forward delivery” contracts under which “commercial users” of a commodity contracted for future deliveries of that commodity at an agreed upon price. The exception was that swaps were based on notional values with no exchanges required in actual physical commodities.
Based on the similarities between swaps and “forward delivery” contracts, yet without the burden of actual ownership or exchange of physical commodities, the swap market based on notional values grew rapidly in the United States during the 1980s. Nevertheless, as a 2006 Congressional Research Service report explained in describing the status of OTC derivatives in the 1980s: “if a court had ruled that a swap was in fact an illegal, off-exchange futures contract, trillions of dollars in outstanding swaps could have been invalidated. This might have caused chaos in financial markets, as swaps users would suddenly be exposed to the risks they had used derivatives to avoid.”
“Legal Certainty” Through Regulatory Exemptions
To eliminate this legality risk, the CFTC and the Congress acted to give “legal certainty” to swaps and, more generally, to the OTC derivatives market activities between “sophisticated parties.”
The CFTC issued “policy statements” and “statutory interpretations” that swaps, “hybrid instruments” (i.e. securities or deposits with a derivative component), and certain “forward transactions” were not covered by the CEA. The CFTC issued the forward transactions “statutory interpretation” in response to a court ruling that a North Sea “Brent” oil “forward delivery” contract was, in fact, a “future delivery” contract, which could cause it to be illegal and unenforceable under the CEA. This, along with a court ruling in the United Kingdom that swaps entered into by a local UK government unit were illegal, elevated concerns with “legal certainty.”
Then, in response to this concern about “legal certainty”, Congress (through the Futures Trading Practices Act of 1992 - FTPA) gave the CFTC authority to exempt transactions from the exchange trading requirement and other provisions of the CEA. In 1993, the CFTC under Wendy Gramm used that authority (as Congress contemplated or “instructed”) to exempt the same three categories of transactions for which it had previously issued policy statements or statutory interpretations. The FTPA also provided that such CFTC exemptions preempted any state law that would otherwise make such transactions illegal as gambling or otherwise. To preserve the 1982 Shad-Johnson Accord, which prohibited futures on “non-exempt securities”, the FTPA prohibited the CFTC from granting an exemption from that prohibition. This would later lead to concerns about the “legal certainty” of swaps and other OTC derivatives related to “securities”.
On September 1, 1999, the United States Court of Appeals for the Seventh Circuit by unanimous decision gave the Chicago Board of Trade (CBOT) permission to trade futures based on the Dow Jones Utilities Average and Dow Jones Transportation Average. This decision overturned a July 1998 decision by the Securities and Exchange Commission (SEC).
For the CBOT this was a giant step towards its goal of eliminating the restrictions of the Shad-Johnson Accord signed in 1982. The Accord resolved a dispute between the SEC and Commodity Futures Trading Commission (CFTC) over regulation of index trading, granting the SEC the right to regulate stock index options and leaving stock index futures under the CFTC’s jurisdiction. However, the SEC was given veto authority over stock index futures. The Court of Appeals basically ruled that the SEC misinterpreted the essence of the Accord.
Similar to the existing statutory exclusion for “forward delivery” contracts, the 1989 “policy statement” on swaps had required that swaps covered by the “policy statement” be privately negotiated transactions between sophisticated parties covering (or “hedging”) risks arising from their business (including investment and financing) activities. The new “swaps exemption” dropped the “hedging” requirement. It continued to require the swap be entered into by “sophisticated parties” (i.e. “eligible swap participants”) in private transactions.
Although the systemic danger of OTC derivatives had been subject to critical warnings in the 1990s and bills were introduced in Congress to regulate various aspects of the market, the 1993 exemptions by the CFTC under Wendy Gramm remained in place. Bank regulators issued guidelines and requirements for bank OTC derivatives activities that reflected some of the systemic concerns raised by Congress, the General Accounting Office (GAO) and other agencies. Securities firms supported SEC and CFTC moves to establish a Derivatives Policy Group (DPG) through which six large securities firms conducting the great majority of securities firm OTC derivatives activities agreed to report to the CFTC and SEC about their activities and adopted voluntary principles similar to those applicable to banks. Insurance companies, which represented a much smaller part of the market, remained outside any federal oversight of their OTC derivatives activities.
In 1997 and 1998 a conflict developed between the CFTC under Brooksley Born and the SEC over an SEC proposal to ease its broker-dealer regulations for securities firm affiliates that engaged in OTC derivatives activities.
The SEC had long been frustrated that OTC derivatives activities were conducted outside the regulated broker-dealer affiliates of securities firms, often outside the United States in London or elsewhere of light regulation. To bring the activities into broker-dealer supervision, the SEC proposed relaxing net capital and other rules (know as “Broker-Dealer Lite”) for OTC derivatives dealers. The CFTC objected that some activities that would be authorized by the SEC proposal were not permitted under the CEA.
On May 7, 1998, the CFTC under Brooksley Born issued a “Concept Release Concerning OTC Derivatives Market” requesting comments on whether the OTC derivatives market was properly regulated under the existing CEA exemptions and on whether market developments required regulatory changes.
The CFTC Concept Release sought public comments to assist it in reexamining its approach to the over-the-counter (OTC) derivatives market. The release was issued as part of a comprehensive regulatory reform effort designed to update CFTC oversight of both exchange and off-exchange markets. CFTC hoped that the comments received will help it in assessing whether its current regulatory approach to OTC derivatives is appropriate or should be modified.
In describing the CFTC action, Chairperson Brooksley Born states: “The substantial changes in the OTC derivatives market over the past few years require the Commission to review its regulations. The Commission is not entering into this process with preconceived results in mind. We are reaching out to learn the views of the public, the industry and our fellow regulators on the appropriate regulatory approach to today's OTC derivatives marketplace."
The CFTC’s last major regulatory actions involving OTC derivatives, adopted in January 1993 under Chairperson Wendy Gramm, were regulatory exemptions from most provisions of the Commodity Exchange Act (CEA) for certain swaps and hybrid instruments. Since that time, the OTC derivatives market has experienced significant changes ­ and dramatic growth in both volume and variety of products offered, participation of many new end-users of varying degrees of sophistication, standardization of some products, and proposals for central execution or clearing operations. While OTC derivatives serve important economic functions, these products, like any complex financial instrument, can present significant risks if misused or misunderstood. A number of large, well-publicized financial losses over the years between 1993, when the CFTC under Wendy Gramm exempted OTC derivatives from CFTC regulation, and May 17, 1998, the date of the proposed CFTC Concept Release, had brought about the attention of the financial services industry, its regulators, derivatives end-users and the general public on potential problems and abuses in the OTC derivatives market. By 1998, many of these losses had come to light since the CFTC’s last major OTC derivatives regulatory actions in 1993.
In view of these developments, the CFTC said it believed it was appropriate to review its regulatory approach to OTC derivatives. The goal of the reexamination was to assist it in determining how best to maintain adequate regulatory safeguards without impairing the ability of the OTC derivatives market to grow and the ability of US entities to remain competitive in the global financial marketplace. In that context, the Commission said it was open both to evidence in support of broadening its existing exemptions and to evidence of the need for additional safeguards. Thus, the CFTC Concept Release identified a broad range of issues in order to stimulate public discussion and elicit informed analysis. The CFTC sought to draw on the knowledge and expertise of a broad spectrum of interested parties, including OTC derivatives dealers, end-users of derivatives, other industry participants, other regulatory authorities, and academicians.
The CFTC emphasized that it was mindful of the industry’s need to retain flexibility to permit growth and innovation, as well as the need for legal certainty. CFTC said its Concept Release would not in any way alter the current status of any instrument or transaction under the Commodity Exchange Act (CEA). All currently applicable exemptions, interpretations and policy statements issued by the CFTC would remain in effect, and market participants could continue to rely on them. Any proposed regulatory modifications resulting from the CFTC Concept Release would be subject to rulemaking procedures, including public comments, and any changes that imposed new regulatory obligations or restrictions would be applied prospectively only.
The 1998 CFTC Concept Release sought comments on a number of areas where potential changes to the 1993 CFTC exemptions might be possible, including eligible transactions, eligible participants, clearing, transaction execution facilities, registration, capital, internal controls, sales practices, recordkeeping and reporting. The release also asked for views on whether issues described in the Concept Release might be addressed through industry bodies or self-regulatory organizations.
The CFTC actions were widely viewed as a preemptive response to the SEC’s Broker-Dealer Lite proposal. Some even suspected such actions as perhaps an attempt by the CFTC to force the SEC to withdraw the “Broker-Dealer Lite” proposal. On May 7, 1998, the CFTC had openly expressed dismay over the SEC proposal and the manner in which it was issued, noting that the CFTC was 18 months into a “comprehensive regulatory reform effort.” On the same day, the CFTC issued its “Concept Release”.
Immediately, three members of the Presidential Working Group (PWG): Treasury Secretary Robert Rubin, Fed Chairman Alan Greenspan, and SEC Chair Arthur Levitt, overruling the dissenting vote of CFTC chair Brooksley Born, issued a letter asking Congress to prevent the CFTC from changing its existing treatment of OTC derivatives. They argued that, by calling into question whether swaps and other OTC derivatives were “futures”contracts, the CFTC was calling into question the legality of security related OTC derivatives for which the CFTC had not authority to grant exemptions (as described in Section 1.1.2) and, more broadly, the CFTC was undermining an “implicit agreement” not to raise the question of the CEA’s coverage of swaps and other established OTC derivatives.
In the ensuing Congressional hearings, the three members of the PWG, Rubin, Greenspan and Levitt, dissenting from the CFTC’s “unilateral” actions, argued that the CFTC was not the proper body, and that the CEA was not the proper statute, to regulate OTC derivatives activities. Banks and securities firms dominated the OTC derivatives market. Their regulators needed to be involved in any regulation on the market. The anti-CFTC members of the PWG explained that any effort to regulate OTC derivatives activities through the CEA would only lead to the activities moving outside the United States. In the 1980s banks had used offshore branches to book transactions potentially covered by the CEA. Securities firms were still using London and other foreign offices to book at least securities related derivatives transactions. Any change in regulation of OTC derivatives should only occur after a full study of the issue by the entire PWG.
CFTC Chair Brooksley Born replied that the CFTC had exclusive authority over “futures” contracts under the CEA and could not allow the other PWG members to dictate or curb CFTC authority under that statute. She pointed out CFTC “Concept Release” did not propose, nor presuppose the need for, any change in the regulatory treatment of OTC derivatives. She noted, however, that changes in the OTC derivatives market had made that market more similar to futures markets.
The 1998 Presidential Working Group (PWG) Report
The 1998 PWG Report recommended:
(1) The codification into the CEA, as an “exclusion”, of existing regulatory exemptions for OTC financial derivatives, revised to permit electronic trading between “eligible swaps participants” (acting as “principals”) and to even allow standardized (i.e. “fungible”) contracts subject to “regulated” clearing;
(2) Continuation of the existing CFTC authority to exempt other non-agricultural commodities (such as energy products) from provisions of the CEA;
(3) Continuation of existing exemptions for “hybrid instruments” expanded to cover the Shad-Johnson Accord (thereby exempting from the CEA any hybrid that could be viewed as a future on a “non-exempt security”), and a prohibition on the CFTC changing the exemption without the agreement of the other members of the PWG;
(4) Continuation of the preemption of state laws that might otherwise make any “excluded” or “exempted” transactions illegal as gambling or otherwise;
(5) As previously recommended by the PWG in its report on hedge funds, the expansion of SEC and CFTC “risk assessment” oversight of affiliates of securities firms and commodity firms engaged in OTC derivatives activities to ensure they did not endanger affiliated broker-dealers or futures commission merchants;
(6) Encouraging the CFTC to grant broad “deregulation” of existing exchange trading to reflect differences in (A) the susceptibility of commodities to price manipulation and (B) the “sophistication” and financial strength of the parties permitted to trade on the exchange; and
(7) Permission for single stock and narrow index stock futures on terms to be agreed between the CFTC and SEC.
In 1998, the disagreement between the CFTC under Brooksley Born and the other three infinitely more powerful members of the PWG involved the scope and purposes of the CEA. CFTC saw broad CEA purpose in protecting “fair access” to markets, “financial integrity”, “price discovery and transparency”, “fitness standards,” and particularly protection of “market participants from fraud and other abuses.” The other three members of the PWG, particularly the Federal Reserve through Alan Greenspan, found the more limited purposes of CEA as (1) preventing price manipulation and (2) protecting retail investors. Other concerns such as fraud should be left to industry self governance.
The 1998 PWG Report ended that disagreement by analyzing only four issues in deciding not to apply the CEA to OTC derivatives, by finding:
(1) The sophisticated parties participating in the OTC derivatives markets did not require CEA protections;
(2) The activities of most OTC derivatives dealers were already subject to direct or indirect federal oversight;
(3) Manipulation of financial markets through financial OTC derivatives had not occurred and was highly unlikely, and
(4) The OTC derivatives market performed no significant “price discovery” function.
The PWG concluded “there is no compelling evidence of problems involving bilateral swap agreements that would warrant regulation under the CEA.”
The majority view of the three powerful members of the PWG concerning the scope and application of the CEA left the CFTC defenseless and permitted a “remarkable” agreement “on a redrawing of the regulatory lines.”
Rather than treat the “convergence’ of OTC derivatives and futures markets as a basis for CFTC regulation of OTC derivatives, the PWG Report acknowledged and encouraged the growth in similarities between the OTC derivatives market and the regulated exchange traded futures market. Standardized terms and centralized clearing were to be encouraged, not prohibited. Price information could be broadly disseminated through “electronic trading facilities.”
The 1998 PWG Report hoped these features would
(1) Increase “transparency” and liquidity in the OTC derivatives market by increasing the circulation of information about market pricing, and
(2) Reduce “systemic risk” by reducing credit exposures between parties to OTC derivatives transactions.
The 1998 PWG Report also emphasized the desire to “maintain US leadership in these rapidly developing markets” by discouraging the movement of such transactions “offshore.”
In the 1998 Congressional hearings concerning the CFTC “Concept Release”, Representative James A. Leach (R-IA), the Leach of Gramm–Leach–Bliley Act (GLBA) of 1999, that repealed part of Glass-Steagall, had tied the regulatory controversy to “systemic risk” by arguing the movement of transactions to jurisdictions outside the United States would replace US regulation with laxer foreign supervision. In other words, the US will compete in a global downward spiral of deregulation to keep its leadership in financial innovation.
The Commodity Futures Modernization Act of 2000 (“CFMA”) clarifies that most OTC derivative contracts would not be subject to regulation; as CFMA would  bar the CFTC, the SEC, and the states from regulating these complex financial products between sophisticated parties. It enacted into law, but also went beyond, the recommendations of a Presidential Working Group on Financial Markets Report entitled: “Over-the-Counter Derivatives and the Commodity Exchange Act.” (PWG Report).
The Enron Loophole
Although hailed by the PWG on the day (December 15, 2000) of congressional passage of CFMA as “important legislation” to allow “the US to maintain its competitive [leadership] position in the over-the-counter derivative markets”, by December 2, 2001,the bankruptcy filling of collapsed Enron brought public attention to the CFMA’s treatment of energy derivatives in the “Enron Loophole.”  .
The Enron Loophole is the nickname for a provision written into the CFMA of 2000 that was drafted by lobbyists for Enron and inserted in the bill by then Senator Phil Gramm that deregulated an aspect of the market Enron sought to exploit with its “Enron On-Line” trading program, the first Internet-based commodities transaction system. While it was a technical success, Enron On-Line was based on a flawed business model that drained corporate revenues - even while the company was manipulating the rates consumers paid for electricity in California. Enron On-Line eventually help drive the company into bankruptcy, and the cooking of the books to hide its losses led to charges of conspiracy and fraud against Enron executives.
In the 1980s, Enron saw a profit potential in speculating on electricity futures if government regulation were remove to permit Enron to corner the market and game the market systematically. CFTC chair Wendy Gramm, exempted Enron from CFTC regulation and made the exemption permanent before she left the CFTC on President Clinton’s inauguration day.
After the 2000 presidential election, in the chaos of constitutional crisis of which candidate had been elected president, Enron got a law passed containing what known as the Enron Loophole. Where the CFTC under Wendy Gramm deregulated individual trades, the Enron Loophole deregulated the entire online trading market which Enron had just started to focus on California.
In the first half of 2001, California suffered 38 rolling blackouts, as Enron legally used artificial shortages, bogus deals and total knowledge of the market as sole owner of its own online market to triple energy bills of California customers. CFTC regulators were totally in the dark as Enron traders laughed derisively at the incompetence of the bureaucracy as the company raked in billions in ill-gained profits.
The Enron loophole applied to all energy commodities, oil, propane, natural gas, not just electricity. Even today, oil futures price are driven by speculators, free from any regulatory oversight. While Americans were told to blame OPEC producing nations for the high cost of oil, American homes had to pay billions more to speculator to heat their homes. In 2004, British Petroleum had to pay $303 million to settle charges it cornered the propane market to inflate heating costs for seven million American homes.
A Senate report recognized what speculators have done and attributed the abuse to the Enron Loophole. The Senate Commerce Committee took testimony about the Enron Loophole‘s effect on the price of oil.
Enron was not the only culprit. Morgan Stanley became the biggest heating oil speculator in New England. In 2006, Amanranth Advisors lost $6.7 billion in natural gas futures placed by a star trader (Brian Hunter). The speculative bubble in petroleum markets cost the average American household about $1,500 dollars in increased gasoline, natural gas and electricity expenditures in the past two years.
As early as 2002, John McCain voted with the minorities in the Senate to close the Enron Loophole. “We‘re all tainted by Enron‘s money,” he told the press. “Enron made a sound investment in Washington. It did them a lot of good. Where they really do well is around the edges, the insertion of an amendment, the Enron Loophole, into an appropriations bill.”
McCain‘s finance co-chair, Wayne Berman, lobbied for Chevron and for the American Petroleum Institute against the Price Gouging Prevention Act. The lobbying firm for which Berman serves as managing director was hired by the New York Mercantile Exchange to lobby against the Close the Enron Loophole Act. McCain’s top campaign adviser, controversial lobbyist Charlie Black, was paid $140,000 by JP Morgan in 2000 to lobby Congress to pass the CFMA that contained the Enron Loophole.
During his presidential campaign, McCain focused on developing alternate energy sources rather than regulation. But unless regulated,  the new, clean energy market will be cornered by big speculator banks and rob those entrepreneurs blind as like they have done to the gas station owners and heating oil dealers around the country. Candidate Obama also had an adviser who lobbied for the American Petroleum Institute.
The “Close the Enron Loophole Act” was a bill introduced by Senator Levin to amend the Commodity Exchange Act (CEA) to close the Enron loophole, prevent price manipulation and excessive speculation in the trading of energy commodities, and for other purposes, was never enacted into law to regulate more extensively “energy trading facilities.”
Following the Federal Reserve’s emergency loans to “rescue” American International Group (“AIG”) in September, 2008, the CFMA received even more widespread criticism for its treatment of credit default swaps (CDS) and other OTC derivatives.
AIG provided insurance out of London in the form of credit default swaps on collateralized debt obligations (CDOs), tradable pools of cash-flow backed securities from mortgages, car loans and credit cards, without adequate capital reserves because insurance policies were not regulated in London. AIG had sold $440 billion in credit-default swaps tied to CDOs that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG’s standing, triggering a clause in its CDS contracts to post billions in collateral that AIG had not provided for. When the market value of the CDOs started to fall as defaults mounted in the US, AIG had to start making additional collateral payments to its customers. By September 2008 it was running out of money.
The Fed took the highly unusual step using legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under “unusual and exigent” circumstances, an authority invoked six months earlier when Bear Stearns Cos. was rescued in March. The $85 billion cash was used in part for AIG to meet additional collateral payments. Then, to draw a line under AIG’s liabilities, the Fed bought out all the CDOs at their mark-to-market value, meaning that none of the counterparties lost a penny (collateral payments plus the market value of the CDOs summed to their face value).
A report prepared by Neil Barofsky, special inspector general for the Troubled Asset Relief Program: “Factors Affecting Efforts to Limit Payments to AIG Counterparties,” criticized the New York Federal Reserve Bank for making “several policy decisions that severely limited its ability to obtain concessions from the counterparties.”
The report criticizes the NY Fed for deciding against treating domestic banks that held AIG credit default swaps differently from foreign banks. That led France's bank regulator to refuse to allow two French banks involved to make concessions when negotiating the amount of payment for credit default swap obligations. The NY Fed failed to use what the report termed its “considerable leverage” over counterparties that it and the Federal Reserve regulated to force counterparties to accept reduced payments for the instruments.
The report also criticized the Federal Reserve for not revealing the identities of AIG's counterparties, which the Federal Reserve argued would undermine AIG and the stability of financial markets.
On August 11, 2009, the Treasury Department sent to Congress proposed legislation titled the “Over-the-Counter Derivatives Markets Act of 2009.” The Treasury Department stated that under this proposed legislation “the OTC derivative markets will be comprehensively regulated for the first time.”
To accomplish this “comprehensive regulation”, the proposed legislation would repeal many of the provisions of the CFMA, including all of the exclusions and exemptions discussed in Sections 4 above that have been identified as the “Enron Loophole.” While the proposed legislation would generally retain the “legal certainty” provisions of the CFMA, it would establish new requirements for parties dealing in non-“standardized” OTC derivatives and would require that “standardized” OTC derivatives be traded through a regulated trading facility and cleared through regulated central clearing. The proposed legislation would also repeal the CFMA’s limits on SEC authority over “security-based swaps.”
The proposed legislation would create new categories of market participants under the Commodity Exchange Act and directs the CFTC and the SEC to adopt joint interpretations of the defined terms, which includes “swap,” “swap dealer,” swap repository,” and “major swap participant.”
In response to the release of the Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”) on August 11, 2009, by the Treasury Department, the Chairman, Gary Gensler, of the Commodity Futures Trading Commission (“CFTC”) sent a letter to Congressional leaders with several amendments and clarifications to the legislation. These changes are intended to expand the CFTC’s authority and to refine the legislation so that it covers “the entire marketplace without exception.”
Under OCDMA, the definition of a swap subject to the statute will not include: any sale of a nonfinancial commodity for deferred shipment or delivery, so long as such transaction is physically settled; equity securities, or foreign exchange swaps or forwards. However, a currency swap will be considered a commodity swap under the proposed legislation, as are credit spreads, credit default swaps, and credit swaps. A major swap participant (MSP) is defined as an entity that is not a swap dealer, but that maintains significant positions in outstanding swaps that are not for hedging purposes.
The proposed legislation requires federal banking regulators, the CFTC, and the SEC to impose strict capital and margin requirements on all OTC derivative dealers and MSPs. Federal banking regulators will have authority over banks that act as swap dealers and the CFTC and the SEC will have jurisdiction over non-bank swap dealers. Swap dealers and MSPs will be required to maintain prescribed levels of capital, daily trading records and records of their communications with counterparties, and will be required to comply with business conduct standards set by the CFTC: to disclose material risks of swap transactions; the source and amount of fees or remuneration that swap dealer/MSP would receive; and other material incentives/conflicts. The CFTC and SEC will be required to “harmonize” their regulatory regimes for swap dealers and MSPs. The proposed legislation raises the significant concern that the definition of swap dealer or major swap participant could reach commercial entities whose working capital constraints will not allow them to meet these new capital or margin requirements.
For customized, bilateral contracts, the end-user will be required to post margin to the swap dealer and the relevant regulatory authority will perform audits of the dealer to ensure that proper margin is posted.
In turn, this may require additional legislative and/or regulatory changes to protect the margin posted by the end-user. Again, the narrow carve-out for non-financial entities using OTC derivative contracts to hedge price risk may limit or make customized OTC transactions inaccessible for non-financial entities that do not qualify for the limited exemption.
For those interested in source documents:
The Over-the-Counter Derivatives Markets Act (OCDMA) of 2009 is available at:
The Treasury Proposal is available at: http://www.financialstability.gov/latest/tg_05132009.html
The CFTC’s Proposal is available at:
Treasury Secretary Timothy F. Geithner, then as President and CEO of the NY Federal Reserve Bank, warned in a speech: Risk Management Challenges in the US Financial System, before the Global Association of Risk Professionals (GARP) 7th Annual Risk Management Convention & Exhibition in New York City on February 28, 2006, seventeen months before the credit crisis that broke out in July 2007, that the scale of the over-the-counter derivatives markets was dangerously large.
“Although the notional total value of these contracts, now approaching $300 trillion, is not a particularly useful measure of the underlying economic exposure at stake, the size of gross exposures and the extraordinarily large number of contracts suggest the scale of the unwinding challenge the market would confront in the event of the exit of a major counterparty. The process of closing out those positions and replacing them could add stress to markets and possibly intensify the direct damage caused by exposure to the exiting institution,” Geithner said.

Geithner observed that credit derivatives, where the gaps in the infrastructure and risk management systems were most conspicuous, were less than 10% of the total OTC derivatives universe, but were growing rapidly. Large notional values were written on a much smaller base of underlying debt issuance. The same names showed up in multiple types of positions—singles-name, index and structured products. These created the potential for squeezes in cash markets and greater volatility across instruments in the event of a default, magnifying the risk of adverse market dynamics.

The net credit exposures in OTC derivatives, after accounting for collateral, were a small fraction of the gross notional values. The ten largest US bank holding companies, for example, report about $600 billion of potential credit exposure from their entire derivatives positions, the total gross notional values of which were about $95 trillion. That left more than $200 trillion of notional value to be reckon with outside the banking sector. This $600 billion “credit equivalent amount” exposure faced by banks was approximately 175% of tier-one capital, about 15% higher relative to capital than five years before in 2001. This measure of the underlying credit exposure in OTC derivatives positions was roughly a fifth of the aggregate total credit exposure of the largest bank holding companies. This was a relatively conservative measure of the credit risk in total derivatives positions, but, for credit derivatives and some other instruments, it still might not adequately capture the scale of losses in the event of default in the underlying credits or the consequences of a prolonged disruption to market liquidity. The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.

Geithner allowed that internal risk management systems have improved substantially since the mid-1990s, but most firms still faced considerable challenges in aggregating exposures across the firm, capturing concentrations in exposures to credit and other risks, and producing stress testing and scenario analysis on a fully integrated picture of exposures generated across their increasingly diverse array of activities. The greater diversity of institutions that now provided demand for credit risk, or were willing to hold credit risk, should make credit markets more liquid and resilient than would be the case if credit risk was still held predominantly by banks or by a smaller number of more uniform institutions, with less capacity to hedge those exposures. However, the financial system still faced considerable uncertainty about how market liquidity would behave in the context of a major deterioration in credit conditions or a sharp increase in volatility in equity and credit spreads, and this uncertainty was hard to quantify and therefore hard to integrate into the risk management process.
Seventeen month later, such clam deliberations were drowned by a once-in-a-century collapse of the credit market.
The Obama administration has been trying to impose regulation on the OTC derivatives market. Led by Gary Gensler, the current chairman of the CFTC, the administration is proposing a bill that would establish an exchange on which derivatives, like stocks and bonds, could be traded. But the question is transparency, without which there will exist a huge information gap between the sellers and buyers of derivatives, making it impossible for regulators to gauge the level of systemic risk.
Yet the five biggest US banking institutions depend on that very information gap to create profit. Of the $291 trillion in notional value of all derivative contracts held by US institutions, 95% is held by the big five: J.P. Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Citigroup. In the first six months of 2009, in the midst of a deep recession, these banks made more than $15 billion trading derivatives. Transparency provided by trading in an exchange would eliminate much of the information advantages now enjoyed by the big five, as pointed by in congressional testimony by Rob Johnson, director of the Economic Policy Initiative for the Roosevelt Institute.
On September 28, 2009, the Office of the Comptroller of the Currency report on banks derivatives trading activities showed that the estimated value of all derivatives held by US commercial banks was rising, increasing nearly 1% over the last quarter and 12% year to year, to $203.5 trillion (total includes interest rate, FX, credit and other derivatives).
Bank holdings of credit default swap (CDS) contracts remain greatly elevated. Although down from their peak in the fourth quarter of 2008, banks hold more than five times the amount in such derivatives than at the end of 2004, when the US economy was taking off.
Banks exposure to derivatives, while falling slightly, remains alarmingly high. Bank of America’s total derivatives-related credit exposure relative to its capital was 137%; Citibank 209% and Goldman Sachs 921%.
Trading credit derivatives is once again highly profitable. After seeing huge losses on these instruments toward the end of 2008 and into first quarter of 2009, banks generated $1.9 billion in cash and derivative revenue in the second quarter of 2009. That is problematic because regulatory reform is still stuck in Congressional committees and subject to industry pressure not to spoil the party. As banks find it difficult to find credit worthy borrowers, they are using their fund to trade derivatives to drive profits. This asset new bubble built by Fed funny money, unlike the previous ones, does not even bother to create an illusion of prosperity, nor full employment.
Once again derivatives are being used not to hedge risk but to generate unsustainable trading profit.  Soon it will be deja vue all over again. But first the world economy needs to recover from the current crisis which may not take hold until 2014. If history is any guide, around 2020 will be the time for the next global market collapse.
November 24, 2009