I was on the UP with Chris Hayes Show today and I talked about the Swaps Execution Facilities Clarification Act (HR 2586), and why I thought it was problematic. Executive summary: it rolls back part of Dodd-Frank that aims to make the derivatives market more transparent.
The Short Version
A good summary of the problems with this bill can be found in the letter against it written by Americans for Financial Reform. Choice quote:
HR 2586 would undermine a key element of derivatives reform – the attempt to create transparent, competitive markets for previously ‘dark’ over-the-counter (OTC) derivatives.
There is also a good explainer from Gretchen Morgenson at the NY Times called “Slipping Backwards on Swaps” that I encourage you to read. Lead quote:
Wall Street loves to do business in the shadows. Sunshine, after all, is bad for profits.
So it is perhaps unsurprising that players in the derivatives market want to thwart one of the worthier aims of the Dodd-Frank financial regulation: to bring transparency to the huge market for instruments known as swaps. Now some in Congress, on both sides of the aisle, are trying to block that goal, too.
The Long Version
But I do want to explain, in nitty gritty detail, why I oppose this bill, and also explain a few things about how this whole rulemaking process works.
The Wall Street Reform and Consumer Protection Act of 2010, better know as Dodd-Frank, introduced a huge number of important regulations meant to stabilize the financial system and reign in the big banks in the wake of the 2008 crash.
Let’s get wonky, and look at the actual definition:
“SWAP EXECUTION FACILITY.—The term ‘swap execution facility’ means a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that
(A) facilitates the execution of swaps between persons; and
(B) is not a designated contract market. “
Asking for prices on OTC derivatives is like Comparison Shopping without the InternetWhat this means in English, is that there now must be a place where you can, as a customer, ask the question “Hey, how much for that fancy Swap you’ve got?” to multiple Swap dealers at the same time. Think of it like comparison shopping on the internet. If you want to know how much that new bike you want costs, you can just type the make and model (Classic Schwinn Red!) into google or bing, and sort by the lowest price.
Compare that to trying to find the best price for your Classic Red Schwinn by calling up every bike store you know of. It’s slow. It’s inefficient. And for all you know, the bike store may change the price when you actually walk in the door. On the internet, there is this ability to immediately purchase the bike–so the price is fixed. On the phone, you just never know.
Wall Street conducts a huge chunk of derivatives business on the phone. They like it that way, because it keeps margins high. Once you have to post your prices in an electronic forum, well, competition starts to arise! Smaller players can try and gain a foothold in the market by charging less. It puts downward pressure on profit margins. Wall Street likes its phone business, thank you very much, and they’re going to try and protect it.
More wonky details
So back to Dodd-Frank 761 and 721. Why are there two sections? Because each section modifies a different law. 721 amends Section 1a of the Commodity Exchange Act, and 761 amends Section 3(a) of the Securities Exchange Act of 1934.
When laws are passed that modify the Commodity Exchange Act, a regulator known as the Commodity Futures Trading Commission (the CFTC) typically has to take the bill and implement it by writing the actual technical, nitty gritty details in a new regulation. They do this once, ask for public comment, and then release a final version of the regulation.
When laws are passed that modify the Securities Exchange Act of 1934, the Securities and Exchange Commission (SEC) goes through the same process as the CFTC.
Why are two Agencies involved, you may ask? Because each Agency governs a different kind of product. The CFTC’s rules on Swap Execution Facilities will apply to index-based credit default swaps (CDS) and interest rate swaps. The SEC’s rules will apply to single name CDS. Don’t worry about the difference if these terms are new to you. All you need to know is that the SEC is in charge of some products, the CFTC other products.
Where are the CFTC and SEC at now with Swap Execution Facilities?
Still with me? Good. So, both the SEC and the CFTC have released draft rules to implement Dodd-Frank 721 and 761. In English, they’ve written draft rules to define what a “Swap Execution Facility” should look like. They have not yet written the final rules. And as sometimes happens, the SEC and the CFTC disagree on a few things.
What they do agree on, is that you should not be able, as a Wall Street Dealer, to only provide price information on the phone. They are still free to use the phone to do their jobs (clients can still call and request a quote on a swap), but they agree to post prices simultaneously to all participants and that all participants have equal access. They cannot show prices to their favorite client first. Brokers already use this method of trading today. It’s called the Voice Hybrid method. Think of it like your non-tech-saavy friend who wants to try the internet, but still needs some hand-holding. The Swap Execution Facility rules say, sure, you can use the phone. But, to go back to our Schwinn example, the person at the bike store also has to post their prices on the internet.
What the SEC and the CFTC disagree on is whether you should be allowed to ask for a price (via this new electronic forum) form only one dealer. The SEC says that’s ok. The CFTC says you need to ask for prices from at least five dealers. I am with the CFTC on this one. More prices, more transparency.
Enter the Swaps Execution Facilities Clarification Act
At its heart, this bill is all about defending the one-on-one phone business, which is at risk due to the Swap Execution Facility Rules.
HR 2586, the Swaps Execution Facilities Clarification Act (full text), is set to hit the House around mid-April. This bill seeks to change this part of the Dodd-Frank Act before the regulators have even finished the final rules. The CFTC and the SEC have proven and thoughtful process that works–we should let them do their jobs.
Rather than requiring clients ask for prices from five dealers, as the CFTC has proposed, the bill says you can’t require a minimum number of dealers to receive price requests (“how much is your Classic Red Schwinn?”). The bill’s logic is that one on one phone calls are best (read: for Wall Street), and requiring that multiple dealers provide prices is bad (read: for Wall Street). So much for trying to make an opaque market more transparent.
What else does it do? Well, it bars the mandating displays of prices. If you don’t want to display prices, you don’t have to, says HR 2586. Again, so much for transparency!
So What Now?
HR 2586 has eight co-sponsors, and will likely hit the House in two weeks. If you think that risky, opaque derivatives trading had something to do with the financial crisis, you may want to think about calling your Congressperson (capitol switchboard is: (202) 225-3121, just ask for your Congressperson by name) and voice your opposition to the Swap Execution Facilities Clarification Act (HR 2586). Tell your Congressperson we need more transparency in the derivatives market, not less.
To learn more:
Finally, here is the portion of UP with Chris Hayes where Rep. Carolyn Maloney and I debate the bill:
And here is part two where Chris wraps it all up.
Please note that this, and all content on my blog, represents only my personal view, not the view of any of the working groups I participate in at Occupy Wall Street.