Comment: the Dodd-Frank donut hole

Comment: the Dodd-Frank donut hole

That catastrophe was caused, in part, by a massive financial world operating largely out of sight of market regulators. Dodd-Frank sought to shove open the door into this tangled garden by increasing the transparency and competitiveness of swaps and other private dealings that, until then, had been concentrated in the hands of a few middlemen.

Organised trading would enable buyers and sellers to find the best price, while clearing houses would absorb credit risk.

How are we doing? Set aside, if you can, the current attempt in the Congress to suffocate the SEC and CFTC by depriving them of the financial oxygen they need to carry out Dodd-Frank. While it is true that, in a democracy, we get exactly the legislators we deserve, that spectacle truly pushes the limit.

Instead, take a closer look at Dodd-Frank, after all the debate and lobbying have subsided. The statute does a marvellous imitation of the bride left at the altar.

An exemption from exchange trading and clearing has been bestowed on commercial firms using swaps for hedging. Does that not amount to most of the swap participants? And since most of their counterparties are swap dealers, the exemption appears to help them too.

One argument for the exemption is that commercial hedgers need bespoke swaps that may not be exactly replicated by instruments standardised for exchange trading and clearing. But through years of effort by the International Swaps and Derivatives Association, the vast majority of swap terms have become standardised already. Might it be possible to use a listed instrument to cover, say, 85% of the risk and a side letter for the outlier terms? This could take Dodd-Frank toward its goal without imposing a one-size-fits-all regime.

Less convincingly, commercial hedgers, including Fortune 500 firms, have persuaded Congress that it would be too costly for them to pay initial margin – typically about 5% of a contract’s value, and satisfiable with high grade bonds that earn interest while on deposit. This may surprise the family farmer who has lived within that system for 150 years.

Another hole will appear in the Dodd-Frank donut if the Treasury Department exercises its authority to exempt foreign currency transactions from Dodd-Frank. This outcome could allow the trillion-dollar-a-day forex business to remain beyond the reach of regulators.

True, most of this activity is between giant banks but, before we relax, who are we referring to when we speak of “too big to fail” institutions, if not them?

And there is a booming retail FX business that keeps the CFTC’s enforcement staff up at night, due to the flim-flam of some dealers.

Both the SEC and CFTC are working round the clock to draft rules for implementing Dodd-Frank, having been given a single year to “reform” the vast over-the-counter derivatives market.

But Congress, with its gaping exemptions, aided and abetted by Herculean lobbyists, has thrown the switch on the tracks and the original plan of Dodd-Frank has headed off in a different direction.