DODD ON DERIVATIVES

WASHINGTON – Today, Senate Banking Committee Chairman Chris Dodd (D-CT) fought attempts to weaken derivatives reform measures in the bill to bring accountability to Wall Street.

 

 “Derivatives are, essentially, bets – bets placed on the future value of something either as a form of protection against changes in that value, or as a way to make money.  Now, there’s nothing inherently wrong with derivatives.  They can be used responsibly as a way to hedge commercial risks,” Dodd said during debate on a Republican amendment to water down reforms.  “But the problem is that, as companies have come up with new and innovative ways to use derivatives, much of this activity has taken place in the shadows, outside the supervision of any regulator.”

 

“The solution is obvious: put an end to risky, uncovered bets that leave taxpayers and our financial system vulnerable.”

 

Dodd explained what the Financial Reform bill would do to improve derivatives regulation, “Instead of an underground gambling club, derivatives will be traded in a well-regulated, transparent market – with rules that must be followed, and safety provisions that must be respected.”

 

And he went on to explain the problems with Republican attempts to weaken these reforms.  “The Republican substitute has no requirement for transparent trading and weakens those safeguards for major market players.  It loosens capital requirements on big Wall Street firms, a huge mistake that would practically beg for another AIG-type crisis.  It limits the central clearing requirement to only those trades that take place between the very largest firms, providing a blanket carveout to other financial firms and letting much of the market continue to operate with no accountability, no transparency, and no regulation.”

 

“It’s the status quo, a system in which companies you’ve never heard of take risks they can’t back up in markets no one can even see.  But when they collapse, we will see the same kind of chaos that AIG’s collapse caused.  And taxpayers will be put on the hook to fill the capital holes.”

 

“This has to stop.  This market needs oversight and regulation.  It’s been months since AIG proved that once and for all.  And it’s time to bring this trail of destruction to an end.  It’s time to pass real derivatives reform,” Dodd concluded.

 

 

“Mr. President, I rise today to discuss a critical aspect of our effort to reform Wall Street: derivatives.  For many Americans who aren’t necessarily experts on our financial system, this is one of the most confusing parts of our work – but it’s incredibly important.”

 

“Derivatives are, essentially, bets – bets placed on the future value of something either as a form of protection against changes in that value, or as a way to make money.  Now, there’s nothing inherently wrong with derivatives.  They can be used responsibly as a way to hedge commercial risks.  Many of us have heard about, for instance, candymakers, who are able to keep their costs stable through the use of derivatives.”

 

“If you’re an end user, and your costs depend on the future prices of a commodity or the future direction of interest rates, derivatives can serve as a form of insurance against an unexpected spike.  But the problem is that, as companies have come up with new and innovative ways to use derivatives, much of this activity has taken place in the shadows, outside the supervision of any regulator.”

 

“And that is how, one night in September of 2008, I found myself listening to Fed Chairman Bernanke and Treasury Secretary Paulson as they explained what had happened to AIG, and what would need to happen to fix it.  Just as some international corporations create shell companies in the Cayman Islands to avoid tax responsibilities, AIG created a subsidiary called AIG Financial Products to sell complex and risky products.  And it was thus able to take advantage of the fact that there was no regulatory requirement that it hold enough capital to cover its exposure to these products.  Meanwhile, because AIG was a AAA-rated company, their counterparties didn’t demand much in the way of collateral or margin.”

 

“Essentially, they guaranteed other peoples’ bets without having the money in place to pay up if those bets failed.  They were able to do so without anyone knowing how many of these guarantees they actually sold.  And they sold trillions.  When it turned out that AIG couldn’t pay up, the government was left holding the bag.  And it took an unprecedented and unpleasant taxpayer bailout to prevent this shocking failure from bringing down our economy.”

 

“AIG wasn’t alone.  Derivatives also helped to mask the creditworthiness of non-financial users such as the government of Greece, to their own eventual detriment.  Hedge funds like Long-Term Capital Management, energy companies like Enron, industrial concerns like Proctor and Gamble, and a wide array of governments at home and abroad have all fallen prey to the problems in our derivatives market.”

 

“The solution is obvious: put an end to risky, uncovered bets that leave taxpayers and our financial system vulnerable.  That’s why capital and margin requirements – imposed either by regulators or by central clearinghouses – are so important.  Chairman Bernanke described margin requirements as ‘an appropriate cost of protecting against counterparty risk.’”

 

“The sad truth is, this solution has been obvious for some time.  In 1994, the GAO produced a report, titled: ‘Financial Derivatives: Actions Needed to Protect the Financial System.’  At the time of their report, the GAO determined the size of the derivatives market to be $12.1 trillion.  The report described risks arising from the interconnected relationship between dealers of derivatives and end users, not to mention the rapid growth and increasing complexity of derivative activities.  Because the relationships between the major derivatives dealers, end users, and the exchange-traded markets were so close, the failure of any one part of this system could prove devastating to our entire financial system.  This we knew in 1994.”

 

“By 2008, the derivatives market had grown from $12.1 trillion to an astonishing $600 trillion.  And, in a related story, it had gone almost entirely underground.  Each time Congress had a chance to act, it chose a legislative path that created more loopholes, more opportunities for these risks to migrate to unregulated pockets of the economy.  In 2000, Congress passed the Commodities Futures Modernization Act, which, to a large extent, explicitly exempted over-the-counter derivatives from regulation by the CFTC and SEC.  And so, whereas in 1998 41 per cent of derivatives were traded in the shadows, by 2008 that proportion grew to 59 per cent.”

 

“Essentially, Mr. President, over time our financial system came up with more and more ways to take bigger and bigger risks, with fewer and fewer safeguards – and less and less supervision.  That is a recipe for disaster, and disaster is what we got.”

 

“That’s why Chairman Lincoln, Senator Reed, Senator Gregg, and many of our colleagues have worked so hard to bring the derivatives market out of the shadows and into the sunlight.  And that’s why the derivatives language in this bill is so important.”

 

“For the first time, over-the-counter derivatives will be regulated by the SEC and the CFTC.  It includes the Banking Committee’s tough requirements for central clearing, exchange trading, capital, margin, and reporting that are critical to reducing systemic risk and ensuring that taxpayers won’t have to clean up the mess resulting from another AIG implosion.”

 

“Now, I know that the financial sector lobbyists don’t like these new rules.  Over 1,000 corporate lobbyists have flooded the Senate in an attempt to water them down.  But Joe Dear, the Chief Investment Officer of the California Public Employees’ Retirement System, explained it well when he said: ‘Every firm has reasons why its contracts are ‘exceptional’ and should trade privately; in reality, most derivatives contracts are standardized – or standardizable – and could trade on exchanges.’”

 

“Thanks to the work of Senator Lincoln and the Agriculture Committee, commercial end users have been carefully exempted from these new rules, so that companies like those candymakers can keep hedging their commercial risks.  And, in fact, the market in which these companies operate will become safer and less expensive because of the new rules for the big players: the swap dealers and major participants.  Those big players – the VIPs in the derivatives casino – will have to register with the SEC and CFTC and meet strict requirements for capital, business conduct, and reporting.”

 

“Every single transaction will be reported through a clearinghouse or trade repository, or directly to a regulator.  The SEC and CFTC will have enhanced authority to police these markets for fraud, manipulation, and abuse.”

 

“The combination of these new regulatory tools will provide market participants and investors with more confidence during times of crisis, taxpayers with protection against the need to pay for mistakes made by companies, derivatives users with more price transparency and liquidity, and regulators with more information about the risks in the system.”

 

“Instead of an underground gambling club, derivatives will be traded in a well-regulated, transparent market – with rules that must be followed, and safety provisions that must be respected.”

 

“Now, as with every other portion of this bill, I welcome improvements.  But, unfortunately, Mr. President, that’s not what the Republican substitute offered by Senator Chambliss would be.”

 

“The Republican substitute has no requirement for transparent trading and weakens those safeguards for major market players.”

 

“It loosens capital requirements on big Wall Street firms, a huge mistake that would practically beg for another AIG-type crisis.”

 

“It limits the central clearing requirement to only those trades that take place between the very largest firms, providing a blanket carveout to other financial firms and letting much of the market continue to operate with no accountability, no transparency, and no regulation.”

 

“It’s the status quo, a system in which companies you’ve never heard of take risks they can’t back up in markets no one can even see.  But when they collapse, we will see the same kind of chaos that AIG’s collapse caused.  And taxpayers will be put on the hook to fill the capital holes.”

 

“This has to stop.  This market needs oversight and regulation.  It’s been months since AIG proved that once and for all.  And it’s time to bring this trail of destruction to an end.”

 

“It’s time to pass real derivatives reform.”

 

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