• The Heritage Network
    • Resize:
    • A
    • A
    • A
  • Donate
  • Missing the Important Issues on Derivatives Reform

    Senator Chris Dodd’s monstrous 1336-page financial reform draft includes a whopping 217 pages devoted to “improving” over-the-counter derivatives markets. Dodd the derivatives section may be replaced by a yet-to-be-released bipartisan compromise from Senators Jack Reed and Judd Gregg. But the Dodd draft suggests that legislators are focused on bureaucratic imperatives rather than improving markets.

    The biggest blind spot in Dodd’s draft is the assumption that only command and control regulation can improve markets. In fact, beginning even before the financial crisis, an international cooperative effort of derivatives market participants led by the New York Federal Reserve has led to significant improvements in the market.

    Over the past 18 months, while Washington dithered, derivatives market participants standardized derivatives products, implemented central clearing, began informational reporting to the public and regulators, and are exploring exchange trading. The Dodd draft is written as if none of this ever happened, perhaps for no better reason than that the steps were not mandated from Washington. In fact, Dodd calls on the industry to achieve just these steps six months or a year after his bill is passed (assuming that ever happens).

    Having Washington pile on now with more regulations will only disrupt what the markets have already achieved, and freeze progress in late 1998 when the concepts in the Dodd draft were first floated.

    Even assuming derivatives require more regulation, Dodd’s second mistake is fixating on who gets the job rather than how it is done. Differing types of derivatives have attributes akin to securities, futures, insurance, and banking products. Derivatives confound jealously-guarded jurisdictional boundaries in existing bureaucracies and, even more disconcertingly for legislators, in Congress.

    Dodd proposes a classic Washington compromise: decide not to decide. The Dodd draft solves the jurisdictional conundrum by giving joint jurisdiction over derivatives to two Washington-based agencies: the Securities and Exchange Commission and the Commodity Futures Trading Commission. Disputes between the agencies are to be resolved by a new regulatory council composed of representatives of those two and yet other financial regulatory bodies.

    In other words, if two commissions with ten commissioners can’t solve the problem, Congress will call in … even more commissions and agencies.

    What’s puzzling is why Dodd ignores the one agency that (a) has experience in regulating derivatives trading and (b) has actually fostered recent major derivatives market improvements: the Federal Reserve Bank of New York.

    It’s not as if Dodd is unaware of the New York Fed: his draft proposes to make the Chair of the Bank a Presidential appointee subject to Senate confirmation.

    There’s no reason for Congress to add another layer of regulation on to this market. Cranking up regulation could in fact make things worse by disrupting the positive changes already taking place. Bureaucrats will disrupt productive markets self-corrective processes and result in unintended consequences. But if Congress does intervene, any steps should reflect the current state of the derivatives markets, not where they stood two years ago. And Congress should give any regulatory authority to an agency with a proven track record at improving markets, rather than creating a gridlock-prone dual-headed scheme.

    Posted in Economics [slideshow_deploy]

    2 Responses to Missing the Important Issues on Derivatives Reform

    1. Rich Stewart, Carlisle PA says:

      Can anyone name a single regulatory program implemented by Washington within the past 75 years that has ended in anything other than a twisted mass of bungling incompetence and undesirable results? I can’t for the life of me come up with one.

      I have to believe that even if he was being just a little sarcastic, the late great Milton Friedman was not far off when he said, “If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand”

    2. Christopher San Fran says:

      Can someone please explain why we do not need a clearing house schematic for debt derivatives? Everyone knows that would be the kick to the pants of guys like GS. The bid ask spread would get crushed and a major source of revenue would get sucked away from the likes of GS and Mother Morgan.

      I will not pretend to understand all of the specific nuances of the Dodd bill, I'm not gonna read that thing. However – continuing to allow these sorts of derivatives to be created at will, anywhere and everywhere without standardization and a clearing mechanisim, and also to allow these institutions to operate with pre-crisis leverage levels is just asking for another melt down.

      Isn't Goldman still a bank holding company? Think about that for a second, then think long and hard about how they make their money. Until we find ways to enforce a curbing of these types of excesses, the joke is still on the U.S. tax-payer in my very humble opinon.

    Comments are subject to approval and moderation. We remind everyone that The Heritage Foundation promotes a civil society where ideas and debate flourish. Please be respectful of each other and the subjects of any criticism. While we may not always agree on policy, we should all agree that being appropriately informed is everyone's intention visiting this site. Profanity, lewdness, personal attacks, and other forms of incivility will not be tolerated. Please keep your thoughts brief and avoid ALL CAPS. While we respect your first amendment rights, we are obligated to our readers to maintain these standards. Thanks for joining the conversation.

    Big Government Is NOT the Answer

    Your tax dollars are being spent on programs that we really don't need.

    I Agree I Disagree ×

    Get Heritage In Your Inbox — FREE!

    Heritage Foundation e-mails keep you updated on the ongoing policy battles in Washington and around the country.

    ×