selise's blog


OTC Derivatives (Which Idiot Decided Not to Regulate Credit Default Swaps?)

November 30th, 2008 by selise

Note: This is part 2 of a series on the (mostly) legislative history of financial deregulation that has contributed to our current financial and economic crisis. For the entire series, including the timeline (where most of the reference links are), see the Financial Regulation Timeline page. Please use the comments to contribute links and other information. Thanks, selise.


In 1992, H.R.707, the Futures Trading Practices Act of 1992 was signed into law. This bill "granted the Commission the authority to exempt over-the-counter (OTC) derivative and other transactions for CFTC regulation." Also in 1992, Congressmember Ed Markey, as chair of the House Subcommittee on Telecommunications and Finance, asked the General Accounting Office (GAO) to report on the potential risk due to the growing use of derivatives. The report was released 2 years later in May of 1994 and warned that the "the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole." This set off a flurry of hearings and in July Markey introduced H.R.4745, the "Derivatives Dealers Act of 1994," to legislate some regulation for OTC derivatives (under the jurisdiction of the SEC). However the bill only had one co-sponsor (Mike Synar) and never made it out of committee.

In January of 1993, just 2 days after Bill Clinton’s inauguration and on Wendy Gramm’s last day as chair, the Commodity Futures Trading Commission (CFTC) exempted "certain swap agreements and hybrid instruments from regulation under the Commodity Exchange Act."

In May of 1998, the CFTC proposed "reexamining its approach to the over-the-counter (OTC) derivatives market" and sought public comment. In particular, Brooksley Born, chair of the CFTC, "was concerned that unfettered, opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it,”… She called for greater disclosure of trades and reserves to cushion against losses." However, senior members of the Clinton administration pressured her to back off and when she did not, Greenspan, Rubin and Levitt asked Congress to act to prevent the CFTC from regulating OTC derivatives. Congress responded with a 6 month restraint period, during which the CFTC "may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement" (language from H.R.4328). After a year of conflict, including a number of contentious Congressional hearings, in January of 1999, Brooksley Born announced she would not be seeking a second term as CFTC chair.

In November 1999, Clinton’s Treasury, Fed, SEC and new chair of the CFTC recommended to Congress in their joint OTC Derivatives Report to Congress that the CFTC be permanently barred from regulating most swaps. Congress eventually did so in the Commodity Futures Modernization Act of 2000:

The act has been cited as a public-policy decision significantly contributing to Enron’s bankruptcy in 2001 and the much broader liquidity crisis of September 2008 that led to the bankruptcy filing of Lehman Brothers and emergency Federal Reserve Bank loans to American International Group[1] and to the creation of the U.S. Emergency Economic Stabilization fund.

Throughout 2000 hearings were held on how to modify the Commodity Exchange Act and several bills were proposed but not passed. Finally, the Commodity Futures Modernization Act was introduced as H.R.5660 in the House on December 14, 2000 and as S.3283 in the Senate on December 15, 2000. Also on December 15, the House version of The Commodity Futures Modernization Act, over 100 pages long and, according to Michael Greenberger, written by investment bank lawyers was attached as a rider the Omnibus appropriations bill (H.R. 4577) while in conference. Later that day, just before adjourning for Christmas and less than 2 hours after it was reported out of committee, the conference report was passed by the House 292 – 60 and by unanimous consent by the Senate before the bill had even been reported to the Senate floor.

Michael Greenberger, who was at the time the director of the CFTC’s division of Trading and Markets has said, "Quite frankly I think at the time anybody who opposed it was deemed to be a little bit crazy." Greenberger and his boss Brooksley Born at the CFTC were two within the Clinton administration who did oppose it.

x-posted at oxdown

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Appendix – BACKGROUND on OTC Derivatives:

notes (1994 GAO report is helpful):

  1. exchange vs otc (privately negotiated bilateral contracts)
  2. derivative types: equity, credit risk, foreign currency exchange rates, interest rates,…
  3. contract types: futures (std contract, on an exchange), forwards (custom contract, otc), options (exchange or otc), swaps (otc)
  4. use: hedge or bet

one type is CDSs – but only one – that is why this is not the perfect storm, it could be worse. !? wonder what the size and risk of other unregulated financial instruments?

credit default swaps (CDS) from wikipedia:

…credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults — a buyer doesn’t necessarily have to own a bond to buy the credit default swap that insures it. When traders buy swap protection, they’re speculating a loan or bond will fail; when they sell swaps, they’re betting that a borrower’s ability to pay will improve.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

It acts like ‘insurance’ but isn’t. "It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ’swap,’ which by virtue of federal law is deregulated," according to Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodity Futures Trading Commission. [22] The deregulation of the swaps market is thanks to provisions in The Commodity Futures Modernization Act of 2000.

Credit default swaps are the most widely traded credit derivative product.[3] The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion [5] to $62.2 trillion [6] worth of credit default swap contracts outstanding worldwide. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide CDS market at $58 trillion, and stated it was "completely lacking in transparency and completely unregulated."[7] The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion[8], while the world’s GDP for 2007 was estimated at $54.3 trillion [9])

In 2007 the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn’t worked because It’s been boycotted by banks, which prefer to continue their trading privately.

It appears that large, but more manageable, losses in the housing market, as the speculative bubble burst, have been amplified by an unregulated market of financial instruments, which appears to be something on the order of the world’s annual GDP. In other words, there is just not enough money in the world to cover the bets that have been made.

Warren Buffett has called called them "financial weapons of mass destruction." Any attempt to seriously address our current financial crisis must take CDSs into account. Hugh in the comments at FDL and bernhard at Moon of Alabama have advocated nullifying them (see also the warning against). From bernhard:

Declare All Credit Default Swaps Null And Void. That would solve 80% of the problems the banks have right now. Some would still fail, but with the big issue removed, interbank lending and commercial lending would carry less risk and revive.

x-posted at oxdown

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