Financial Reform: One Tough Anti-Derivatives Measure is DOA, and Others May Follow

Financial regulation amounts to a perpetual game of Whac-a-Mole: Flatten risk in one quadrant of the banking world and it pops up in another. With that axiom in mind, it's fair to ask whether any of the legislative proposals for reining in over-the-counter derivatives will work to curb Wall Street speculation.

Under the boldest such plan, Sen. Blanche Lincoln would force banks out of the derivatives business altogether. But support for that idea is waning fast. In an April 30 letter to the Arkansas Democrat and to Senate Banking Committee Chairman Chris Dodd, D-Conn., FDIC chief Sheila Blair said such restrictions would drive derivatives trading toward hedge funds, foreign financial firms and other deregulated corners of the market.

Bair is the fastest regulatory gun in Washington, with a reputation for being tough on Wall Street. Her move to question Lincoln's proposal will undermine already tenuous congressional support for the amendment. Other Senate Democrats, along with most Republicans and the White House, also have concerns with the plan.

Banks are pleased. Writes Jaret Seiberg, an analyst with financial industry advisory firm Concept Capital, in a new report (no public link):

Let's start with the positive news. As each day goes by, we believe momentum is increasing to strip out the prohibition on banks' operating derivatives units.... In addition, Federal Reserve staff oppose the measure. And we hear the administration does not favor it either. In our view, momentum is building to eliminate this provision, and we expect it to be dropped as part of the Senate process.

That part of the Dodd bill is likely to survive. There's also significant congressional support for provisions that would standardize many derivatives, which would make them easier to monitor, and require banks that deal in swaps to hold more capital.

These are worthy changes. Assuming they pass muster on Capitol Hill, however, my concern is what happens next.

Big banks, which are the largest derivatives dealers, have $30 billion in revenue on the line. They're desperate to remain at the center of that market. As such, these institutions aren't merely working to dilute derivatives limits in the Dodd bill -- they'll also be studying how to game whatever rules are imposed.

Oh, c'mon, you say! How much damage could they really do with a new law on the books?

A lot. Even if standard derivatives are traded on industry exchanges, there's nothing stopping Wall Street from lobbying Congress down the road for exemptions to certain kinds of trading. And once President Obama has signed the financial reform bill into law and the November election has passed, it's not hard to imagine lawmakers playing ball.

Yet banks could subvert the regs in other ways. Robert Litan, a senior fellow at Washington think-tank the Brookings Institution, notes in a recent report that under financial reform big banks will maintain control over how derivatives are priced through their ownership of Markit, a data warehouse used to process OTC trading in the instruments.

Wall Street also looks likely to have a lock on how derivatives are cleared through their control over Intercontinental Exchange, the country's largest derivatives clearinghouse. The Dodd bill would effectively steer more business to the company, which is owned by such firms as Bank of America (BAC), Goldman Sachs (GS) and JPMorgan Chase (JPM).

Under such conditions, it's not clear what financial reform does to stem banks' influence over the derivatives market. Litan writes:

[T]he dealers are thus likely to resist or drag their feet implementing changes that would reduce systemic risk in the financial system as a whole but that could significantly reduce the dealers' revenues and related profits from the current arrangement or that make these flows more volatile.