Page 1 of 5 DERIVATIVE MARKET REFORM, Part 1 The folly of deregulation
By Henry C K Liu
On October 7, 2009, the United States House of Representatives Committee on
Financial Services at long last held a public hearing on "Reform of the
Over-the-Counter (OTC) Derivative Market: Limiting Risk and Ensuring Fairness".
OTC derivatives are contracts executed outside the regulated exchange
environment whose values depend on (or derive from) the values of underlying
assets, reference rates or indexes. Market participants use these instruments
to perform a wide
variety of useful risk management functions. The Bank of International
Settlement (BIS) reports that the notional value of all outstanding OTC
derivative contracts ending June 2009 was US$49.2 trillion worldwide against a
2009 world gross domestic product (GDP) of $65.6 trillion.
In the US, congressional hearings are the principal formal venue by which
committees collect and analyze information in the early stages of legislative
policymaking. The House Committee on Financial Services oversees and formulates
policies and develops legislation that govern the entire US financial services
industry, including the securities, insurance, banking, and housing industries.
The committee also oversees the work of the Federal Reserve - the central bank
- the Department of the Treasury, the Securities and Exchange Commission, and
other financial services regulators and agencies.
As such, its mandate covers the OTC derivative market, which has been a major
source of systemic risk in financial markets. The committee is at present
chaired by Representative Barney Frank, Democrat from Massachusetts, with
Republican Spencer Bachus from Alabama as ranking member.
Witnesses initially called by the committee for the hearing were all derivative
industry representatives. The list included Jon Hixson, director of federal
government relations at Cargill, an international provider of food,
agricultural, and risk management products and services that relies heavily
upon futures and OTC markets. Cargill is an extensive end-user of derivative
products on both regulated exchanges and in the OTC markets. It also offers
risk-management products and services to commercial customers and producers in
the agriculture and energy markets.
Also on the list was also James Hill of Morgan Stanley, appearing on behalf of
the Securities Industry and Financial Markets Association, Stuart Kaswell of
the Managed Funds Association which, through one of its lobbyists, has
delivered significant "bundled" donations to Congressman Frank. Another witness
was Christopher Ferreri of the Wholesale Markets Brokers Association. All are
or represent beneficiaries of deregulated derivative markets.
Robert A Johnson, director of financial reform at the Roosevelt Institute, was
added as a witness at the last minute after protests made to Frank by Americans
for Financial Reform, an organization of some 200 citizen groups advocating the
interests of consumers, labor unions and small businesses. Johnson prepared an
opening statement that focused, among other concerns, on the "structurally
dysfunctional money politics system" that allows legislators to be improperly
influenced by well-financed industry lobbyists and campaign contributions.
Johnson's point was validated by the fact that his opening statement was cut
short by Congresswoman Melissa Bean, Democrat from Illinois, who chaired the
meeting in the absence of Frank and whom Harpers Magazine described as "another
industry-funded committee member". Johnson's written statement was kept off the
committee's website on a manufactured technicality, presumably to suppress
awkward public exposure of Wall Street financial support to Democratic
legislators.
The draft of the reform bill that is the subject of the committee hearing fails
to call for the establishment of a special exchange for OTC derivatives as
proposed by some reformers. It proposes instead to establish a clearinghouse,
which is a weaker vehicle for tracking OTC derivative transactions. But it also
would allow banks and their counterparties to be exempted from posting such
transactions to the clearinghouse if the parties do not wish to, by simply
claiming that their derivative contracts do not fit into standardized formats
enough to benefit from centralized clearinghouse practices.
An earlier draft of the bill would even have exempted transactions designed to
hedge risk. Since practically all speculative derivative contracts contain
elements of risk hedging, it would mean that essentially all derivative
contracts could be exempted.
In an interview with Democracy Now, Johnson characterizes the reform bill as
"too tepid, too weak, too late ... Very industry influenced. We had a crisis
and they are pandering to the perpetrators."
All may not be lost. The legislation also has to pass the House Agriculture
Committee, chaired by Congressman Collin C Peterson, Democrat from Minnesota,
which is more likely to include a requirement that derivative contracts be
traded on an exchange, or at least that banks and companies report their
derivative contracts to a clearinghouse. "As things stand now, I'd be more
inclined to support the Ag bill," says Frank.
Johnson, allowed to testify before Senate Agricultural Committee, reveals four
major flaws in the financial sector.
Reform towards deregulation
Finance deregulation took a great leap forward with securities litigation
reform after the Republicans captured the House of Representatives in November
1994 in president Bill Clinton's first mid-term election, which lost control of
Congress to the Republicans.
The Private Security Litigation Reform Act of 1995 (PSLRA) was passed easily by
a Republican-controlled Congress and, with Democrat support, even overrode a
perfunctory presidential veto. The law was signed into law by a deeply wounded
Democrat president who desperately needed Wall Street financial support to win
a second term. It is a testimony to Clinton's political ingenuity that the
orchestrated bipartisan veto allowed him also to avoid losing campaign
donations from trial lawyers.
PSLRA was ostentatiously directed at aggressive security litigators, the most
successful of whom was Bill Lerache, who had recovered billions for
shareholders victimized by security fraud committed by management. Lerache and
other partners in Milberg Weiss later pleaded guilty to making "false material
declarations under oath" in federal court proceedings, allegedly intended to
conceal $11.3 million in secret payments and kickbacks that the firm was said
to have paid to named plaintiffs in more than 225 class actions suit in order
to secure the standing to file the class action suits. Still, the suits that
Lerache successfully brought were themselves of undisputable legal merit.
PSLRA made security fraud cases more difficult for plaintiffs to win. It
reflected the belief prevalent among those in charge of the financial system
that the market is the best self-regulating mechanism against fraud and abuse
out of self interest, without the need for added legal constraints. Alan
Greenspan, at the time the chairman of the Federal Reserve, Robert Rubin, the
then secretary of the Treasury, and Arthur Levitt, the then chairman of the
Security Exchange Commission, all were strong believers of the myth of market
self-regulation and used their considerable influence to help create a
deregulated regime in structured finance.
Skeptics of self-regulation
There were skeptics of market self-regulation. James S Chanos, head of Kynikos
Associates, a short-selling hedge fund with $3 billion under management, was
known for being the first to question Enron on its accounting fraud and for
tipping Fortune magazine reporter Bethany McLean on it. He testified before the
House Committee on Energy and Commerce on February 6, 2002, that PSLRA was
responsible for the dramatic increase of fraud from 1995 through 2001 and that
the statute "has
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