Geithner announces plan to regulate derivative trading

Treasury Secretary Timothy Geithner just announced that

Today, ... the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives.

Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad.

Unregulated, un-reported, and un-collateralized derivates are a huge part of the reason behind the biggest financial crisis since the Great Depression in which we find ourselves.

I have been very critical of President Obama and Secretary Geithner previously for their kowtowing to banksters, but the framework unveiled this afternoon is Big News, and it is (yes, truly) Good News. The text of the announcement and some instant analysis below.

From the announcement:

Objectives of Regulatory Reform of OTC Derivatives Markets

Preventing Activities Within The OTC Markets From Posing Risk To The Financial System
– Regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk:

The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP):
- CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.
For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.
- All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:
- Conservative capital requirements
- Business conduct standards
- Reporting requirements
- Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts

Note the limitation of the above provision: it only applies to "standardized" OTC derivatives. Without getting in to too much detail, one of the biggest problems in attempting to resolve the financial crisis has been the lack of standardization in the contracts, worth $Trillions, by all kinds of parties including municipalities, pension funds, and insurance companies in addition to the usual culprits.
But as to those financial instruments that are standardized, the proposal is that there must be a clearing house (the New York Stock Exchange, or the Chicago Mercantile Exchange are examples). A big part of why nobody knows what certain derivatives are worth is, there is no public system to trade them. When Intel stock trades at the Nasdaq, or Ford at the NYSE, everybody else instantly knows the market price. Furthermore, like a central bank clearinghouse, many daisy-chain trades can be unwound or cleared with a minimum of actual cash changing hands. Your savings bank doesn't have to send $1Million every night to a clearinghouse when the net change of all incoming and outgoing checks might only be $10,000.
In summary, even exotic derivatives like CDOs and CDS's, that are standard, are to be traded through a public, transparent, regulated and capitalized entity similar to the NYSE.
This is good.

Promoting Efficiency And Transparency Within The OTC Markets -- To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes:
- Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:
- Recordkeeping and reporting requirements (including audit trails).
- Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
- CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
- CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators.
- The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
- The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
- The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

Another big problem that led to last year's meltdown is that nobody know just how much buying/selling on margin was out there, and how leveraged all of the participants were. Only when the crash loomed were we able to see -- in retrospect, after the disaster -- just how much money had been borrowed to bet on derivatives. The above proposal is designed to ensure that the regulators have a handle on just how much trading is going on, and how much borrowing/leverage is in the system.

Preventing Market Manipulation, Fraud, And Other Market Abuses The Commodity Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and the SEC have:
- Clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses.
- Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets.
- A complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators.

I'm not sure how much of this part is actually new. Certainly the Fed and the SEC already had ample authority, that they chose not to use because of their ideological blinders. What appears most significant is the "authority to set position limits", which may mean that if regulators see there is too much borrowing or leverage in the system, they can act to halt its expansion to the point where the borrowing/leverage creates a risk to the entire system.

Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent.
The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.

This is straightforward. Again, how much of this is really new, vs. already on the books but not enforced due to ideological purity, is questionable. But certainly protecting unsophisticated investors like municipalities or your Aunt Minnie who saved parsimoniously and has $1 million investable assets, is certainly part of any fix.

A final note: all of the above is just a proposal. It will have to work its way through Congress. We already know what the position of the Party of No will be. Whether the feckless Harry Reid and the spineless Senate will enact meaningful reform is, well, questionable, as is how much political capital Obama is willing to spend to get this part of his agenda enacted.

But, to repeat, this is Big News and it is Good News. If only it had been in place for the last 10 years ....




He also got some big brownie points on the corporate tax code recently.

I want more details before I believe it though but I agree with you (I wrote a "pre-story" over in the Instapopulist) that this is a very good sign.

But will they get down into the nitty gritty on some of these derivatives themselves. I frankly want the entire mathematical models "validated". From what I see a lot of these CDOs they are about as validated as betting on the Kentucky Derby by calculating the average diameter of hat size and then mapping that onto the horse's name length, calculated of course by numerology methods.

Also, "nonstandardized" instruments are only reported on

Imho, nonstandardized instruments must be severely limited. Simply knowing that there are, say $10 Trillion in such contracts out there, so there's huge risk/cost to unwinding the positions, isn't terribly helpful.

I keep thinking back to the fact that Barney Frank has already decided to slow-walk banking reform in the Congress.

This is an unabashedly good announcement, but I want to see some rubber hit the road!

no kidding

And they also don't want it to be realized that the glorified Dutch tulip bulbs you are referring to are worthless and that's what I'm after. So, chicken-egg problem, winding it down, getting money back once realized trading widgets not connected to anything useful.

I was into my twentieth year as a series 7 guy

during the roar of the I tried my best to show people that the dot com was false and would eventually blow up. But people just wanted what they want.....make the highest return. I had to tell quite a bit of clients to find another guy, a gentle way of firing clients. I was worried about their principal and they were worried about making as much as their neighbor. I saw more greed/need and want from the public than I care to think. It was too much to handle and in 1999 I sold my business. I wanted OUT!

I also saw how the big wire-houses worked hand in hand with NASD (now FINRA), and the SEC to have rules promulgated in their favor. They didn't like competition from independents such as me.

So it is no surprise to me that the New York exchange is out of reach. New York exchange as a clearing house? Maybe something changed but either the brokerage houses cleared their own (self clearing) or they used their party clearing frims like Pershing. I wouldn't feel comfortable making New York Exchange as a clearing house. That's like having the fox in the hen house.

Robert as you say, the govt and others don't want the secret to get out to the people.

When derivatives first came out the joke was, "what is a derivative?" is what ever you want it to be. You will still have a trading instrument that is not well defined, why have it? In one word greed.

In 1982 when I was a commodity trader you would have never, ever seen a CalPERS in the commodity market. One thing that defined benefit plans did was that it made the person managing the investments to be prudent. If memory serves me, in a court of law, a fiduciary responsibility is a bigger stick than the Prudent Man rules.

So you have the never ending want of the people, you have the greed of the new Wall Street bubble world and I am to think this will change things. I started out with all the zeal in the world, my client was not going to be the well heeled, I wanted to help the people that needed help, to teach them how to plan for their future. In the end, I was a shell, jaded from what I saw in Americans.

Now the PTB want to blow up another bubble. I wonder if Vegas has given odds on it?

Given that

I think the perfect answer to such destructive greed would be a 95% windfall profits tax on any credit-related insurance policy.

That ought to take the wind out of the sails pretty quickly.
Executive compensation is inversely proportional to morality and ethics.

Maximum jobs, not maximum profits.

If the Senate has to approve it, forget it.

Democrats just voted down Bernie's bill to cap interest charged by credit cards at 15%. Democrats aren't going to do anything. We need a third party, or the unions and activists everywhere need to join together to make the obstructionists Democrats pay.

They're asking for another four years -- in a just world, they'd get 10 to 20 ~~ Dennis Kucinich