Casino Royale

by Thomas Brom

Nothing focuses the chief executive's attention like losing a critical U.S. Senate seat. In late January, President Barack Obama challenged the nation's banks to "a fight I'm ready to have" over financial reform and speculative trading. "We intend to close loopholes that allowed big financial firms to trade risky financial products like credit default swaps and other derivatives without oversight; to identify systemwide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to insure that the failure of any large firm does not take the entire economy down with it."

But Obama failed to mention the fate of his Over-the-Counter (OTC) Derivatives Markets Act of 2009, which was chewed up in the House just a month before. The administration's initial proposal emerged from Rep. Barney Frank's House Banking Committee as part of a package of bills voted on separately and reassembled as the Wall Street Reform and Consumer Protection Act of 2009. That 1,279-page bill passed in December without a single Republican vote; a parallel bill sponsored by Sen. Christopher J. Dodd is still being debated.

The key phrase driving would-be regulators is "systemic risk," the really bad kind that spills over from Wall Street to the real economy on Main Street. Since the financial crash of 2008, fear of aftershocks has generated enormous interest in risk management. Enterprise risk management - or policies and practices designed to assess and mitigate companywide risks - entails compliance with everything from the Sarbanes-Oxley Act to the rules and regulations of the Securities and Exchange Commission (SEC). It includes compliance with Delaware case law, which limits the liability of corporate boards under the business judgment rule. Last year, SEC Chairman Mary Schapiro even created a Division of Risk, Strategy, and Financial Innovation - directed by Henry T. C. Hu, a former University of Texas law professor and an expert on derivatives, hedge funds, and corporate governance - to better understand risk management.

But OTC derivative contracts involve exposure to uncertainty - which lacks the observable probability distribution associated with risk. The contracts can be used as options, forwards, or arbitrage. "An OTC derivative is an incredibly versatile product that can essentially be engineered to achieve almost any financial purpose," Hu told Congress last October.

The enabling magic here was provided by the Commodity Futures Modernization Act (CFMA) of 2000, which exempts OTC transactions between banks and broker-dealers from regulatory oversight. Under the CFMA, derivative contracts aren't securities and they aren't traditional futures contracts either. A derivative "is fundamentally a bet," writes New York financial analyst Nasser Saber in Speculative Capital and Derivatives (Prentice Hall 1999). "Arbitrage opportunities are many and varied; hence the confusing array of derivatives and the tortuous legal documentation that must accompany each."

This incredible complexity frustrates attempts at oversight, which the Obama administration proposes to split between the SEC and the Commodity Futures Trading Commission (CFTC). "The regulators never understand," says Ernest T. Patrikis, a partner in the New York office of White & Case who served as general counsel during his 30 years at the Federal Reserve Bank of New York. "They're always somewhat behind - and I was one. You just try to keep the space between you and the banks as narrow as possible."

Brooksley Born, a member of the congressional Financial Crisis Inquiry Commission and former chair of the CFTC, called for regulation of OTC derivatives in the late 1990s but was ignored. In testimony last year, she said, "The market is totally opaque and is often referred to as 'the dark market.' It is enormous. At its height in June 2008 the reported size of the market exceeded $680 trillion in notional value [the total of underlying assets], or more than ten times the gross domestic product of all the countries in the world." All this, Born pointed out, was generated by a handful of major banks and broker-dealers.

In early December bank lobbyists and the Coalition for Derivatives End-Users - a group of 171 business organizations and nonfinancial corporations - carved big holes in the administration's original bill. When the dust settled, it no longer required banks to trade standardized contracts on regulated exchanges, and it exempted end-users trading customized OTC contracts from most of the rules.

"The exemptions are so wide," says Christopher Whalen, cofounder of Torrance?based Institutional Risk Analytics. "There were two main issues for the dealers: If derivatives were put on exchanges, the spreads would compress, and the contracts and prices would no longer be private - the buyers would see everything. The OTC market is basically a bucket shop that creates gaming opportunities for the banks."

Whalen predicts that the big banks "will fight to the death" to preserve bilateral relationships for customized derivatives trading. "And if I'm Exxon Mobil, I'm willing to shill for [CEO] Jaime Dimon at JPMorgan Chase. These rules will leave us all as second-class citizens against the banks."

"It's an unregulated market right now, and obviously the large banks like it as it is," says Thomas O. Gorman, a partner in the Washington, D.C., office of Porter Wright Morris & Arthur who blogs at SECactions.com. "Because the definitions regarding customized contracts aren't tight, we're not getting at the root of the problem."

Ron Papanek, a risk market strategist at RiskMetrics Group in New York, says the House bill at least promotes transparency in OTC trading between banks. But the House legislation still permits cash settlements by counterparties with no direct economic interest in the underlying assets, which encourages speculation.

So best of luck to President Obama. The prospect for managing systemic risk brings to mind lyrics to an old Carter Family song: God gave Noah the rainbow sign; / No more water; the fire next time.

---