Financial “Reform”

According to the Wall Street Journal:

…Banks [will be allowed] to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk. 

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

At one level, this makes sense.  Banks can use the markets to hedge risk, but would set up separately capitalized companies to speculate.  But that isn’t what the article says, and it’s not clear that’s what legislators have in mind.  And it shows they still don’t understand the problem.

Classifying tradeable derivates on the basis of how lawmakers perceive their risk is like classifying road repairs based on how lawmakers perceive the sturdiness of the bridge.  Al Franken probably drove back and forth across the I-35 bridge all the time, never guessing that it was unsound, and I can guarantee you he knows even less about what constitutes a “risky” derivative.

I still think the proper distinction here is between hedged and unhedged risk.  If the bank is sitting in the middle between two sets of counter-parties, it’s at considerably less risk than if it’s speculating on a directional move, or if it could get killed by a large directional move.

The other derivative legislation largely mirrors what Eric Janszen talked about on the Bubble show:

Would for the first time extend comprehensive regulation to the over-the-counter derivatives market, including the trading of the products and the companies that sell them. Would require many routine derivatives to be traded on exchanges and routed through clearinghouses. Customized swaps could still be traded over-the-counter, but they would have to be reported to central repositories so regulators could get a broader picture of what’s going on in the market. Would impose new capital, margin, reporting, record-keeping and business conduct rules on firms that deal in derivatives.

This is a big change, and pardon me if I doubt the ability of regulators to actually understand what’s going on in the market in any way that lets them steer clear of crisis.  But on the whole, more transparency is better.  I am given to understand, however, that the exchanges, which are nominally supposed to adopt the underwriting risk of the contracts, would themselves be backstopped by the government.  So much for ending “too big to fail.”

Cross-posted on Backbone Business.

UPDATE: Additional thoughts here.

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