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Could Wall Street Actually Lose in Congress?

Something strange and a little disorienting is happening in the fight to reform Wall Street: It looks like the reformers are actually starting to win.

This is not something you could have said as recently as six weeks ago. Back then, House Financial Services Committee Chairman Barney Frank had just released a proposal to regulate derivatives, essentially bets on the movements of other assets (like stocks, bonds, commodities) or interest rates. Derivatives are in some respects the key battle in the broader regulatory campaign. They were at the center of last fall’s financial crisis--Lehman’s balance sheet was stacked with them, and they triggered AIG’s collapse. But because they’re so poorly understood by the general public, the fight has unfolded almost entirely in Congressional backrooms, where the banks and their lobbyists naturally have the upper hand.

Frank’s "discussion draft" seemed to reflect that. The proposal the Obama administration unveiled this summer would have forced banks and hedge funds to trade derivatives on exchanges and “centrally clear” them. Clearing means inserting a well-capitalized middleman between two parties on either side of a trade. When derivatives trades are cleared, the failure of one institution doesn’t threaten everyone else it has traded with, which is what happened with Lehman. The only downside is that clearing requires the trader to post margin--a kind of cash cushion--to the middleman, which they’re generally loath to do. Before long, dozens of companies were flocking to Congress to plead their case.

In order to ensure the measure’s eventual passage, Frank found himself having to strike a deal with a group of moderate New Democrats on his committee. The so-called “end-user exemption” they settled on would give a pass to  industrial companies that use derivatives simply to hedge the risk that, say, oil prices or interest rates might rise. The thinking was that hedging by the Caterpillars and the 3Ms of the world wasn’t what brought down the financial system last fall; it was speculation by the likes of Lehman. The New Dems who supported the compromise argued that it would only exempt some 15 percent of standardized derivatives contracts. (That is, contracts that follow a straight-forward template, which reformers want to force onto exchanges.)

But independent experts who studied the measure came to a different conclusion: that it could exempt between 60 and 80 percent of the standardized market because of its vague wording, including many firms who were speculating rather than simply hedging risk. A few days after Frank unveiled his draft, Commodity Futures Trading Commission Chairman Gary Gensler, official Washington’s leading advocate of regulating derivatives, testified about his concern that the compromise “could have the unintended consequence of exempting a broad range of entities,” possibly even major Wall Street firms.

Which, as it happens, was precisely the idea. Though the end users arguably had a legitimate gripe, the banks had long viewed them as a means to deflect additional regulation. “The original plan on derivatives was basically pushed by the industry,” says one bank lobbyist. “What they wanted was, ‘Hey, let’s get the dopey end users to go out and be the face of reform. We don’t have the credibility.'” This lobbyist says the banks helped organize a group called the Coalition for Derivatives End Users, which weighed in with Congress in favor of a robust end-user exemption. (Participants in the coalition, which includes several industry umbrella groups, say their interest in the issue grew out of a concern for their members’ bottom lines. An early derivatives bill "set off alarms with a lot of our member companies," says Dorothy Coleman of the National Association of Manufacturers, which is part of the coalition. Officials at the Business Roundtable and the U.S. Chamber of Commerce, also part of the coalition, did not respond to requests for comment.)

But a funny thing happened on the way to securing the loophole: A confederation of consumer and investor groups, labor unions, environmental activists and a progressive organization called Americans for Financial Reform (AFR) started raising hackles of their own. In several meetings with Frank, these groups stressed that the exemption was too porous, and that it wasn’t just an obscure, technical issue of interest only to banks, regulators, and lobbyists. “This may be bizarre, but you could lose seats over derivatives,” says one member of the coalition, reflecting on the back-and-forth with Frank and his staff. “The perception that nothing serious is being done about fixing casino economy--combined with TARP, high unemployment--could be fatal.” AFR went so far as to commission a poll showing 44 percent of voters  in 77 competitive congressional districts strongly favored tougher regulation of complex financial instruments like derivatives, versus only 14 percent who opposed it.

Gensler’s own role can’t be overstated. A former Goldman Sachs partner who served as Treasury under secretary in the late 1990s, Gensler’s nomination to the CFTC aroused suspicion among congressional liberals when the Obama transition team announced it last December. But Gensler spent several months persuading regulatory hawks that he was one of them, and his actions as chairman underscore it. “The reason I think the left and these consumer groups are in good position is that they have Gensler at the CFTC,” says the bank lobbyist. “He’s turned a rinky dink commission into the most powerful agency in the federal government when it comes to derivatives. … This guy is the guy with the schwag.”

By early this month, the pressure from Gensler and the progressive groups had the desired effect. Though Frank believed their concerns were somewhat overblown, he pronounced himself open to tightening the language to make sure the bill didn’t give speculators a pass. “Barney likes to say redundancy is your friend,” says one financial services committee staffer. “If people have concerns, we’ll tighten up the language … hedging done by corporations is what we’re looking to protect.” On November 3, Frank sent a letter to Gensler and his SEC counterpart Mary Schapiro saying he intended to “clarify exactly who can claim the exception from the clearing and trading requirement.”

Almost everyone agrees that when the legislation comes to the House floor in mid-December, as currently expected, it will largely prevent anyone other than bona fide end users--the 3Ms and Caterpillars--from evading the new regulations. “We are continuing to look at the language, trying to refine it,” says New Dem Mike McMahon of New York, a proponent of the exemption. “To make sure it does what want it to do: allow end users--manufacturing companies, agricultural companies, production companies--continued access [to derivatives] but regulate the speculation side.”

As with most legislation, the real fight now appears to be in the Senate. Throughout much of the summer and fall, the banks approached the House as though they were playing with, well, house money: A big exemption would almost certainly survive the Senate, but a tough bill could be softened up there. That logic may still apply. But the Senate calculus has recently been scrambled. Two weeks ago, Senate Banking Committee chairman Chris Dodd unveiled his own regulatory proposal, including a derivatives measure tougher than anything the House has discussed. Even Dodd himself doesn’t expect it to pass whole cloth. “He’s put his ideal bill out there,” says a Banking Committee staffer. But, if nothing else, it shifts the debate’s center of gravity further to the left and makes a tough reform package more likely.

The bank’s last best hope may be the Senate Agriculture Committee. The committee shares jurisdiction over derivatives because farmers have historically used the instrument to protect themselves from fluctuations in the price of crops. When Sen. Blanche Lincoln of Arkansas, the committee chairman, kicked off hearings on derivatives last week, she seemed intent on working with Saxby Chambliss, the committee’s ranking Republican. “Senate ag is the one committee committed to being bipartisan,” says a securities industry representative. “They will have Republicans participating [which means] we may get close to, beyond where we were on October 2.” Translation: The fight isn’t over just yet.