Felix Salmon

Closing loopholes

By Felix Salmon
December 10, 2009

Remember how Gary Gensler persuaded Barney Frank to close a big loophole in the derivatives-regulation legislation? I was hopeful then — poor, naive soul that I am — that the banking lobby had been effectively neutered on the loophole front.

Of course it hadn’t: it just started looking for another loophole instead. Remember that the main point of the legislation is to force all derivatives trading onto an exchange. The first loophole tried to get around that by saying that “end users” could get a pass; inevitably, all the major banks would somehow manage then to define themselves as end users.

The new loophole, as explained by Mike Konczal, takes another tack. It says that you don’t need to trade derivatives on exchange — you just need to trade them on an exchange or a “swap execution facility”. And then it defines “swap execution facility” so broadly that two traders talking on the telephone — just like they do in the current OTC market — can be considered such a thing.

There’s been enough publicity surrounding this loophole that it might yet get closed. But the bigger picture is clear: Wall Street, in the pursuit of large profits, will always try to find a way around regulations it doesn’t like. And eventually it’s going to succeed. Which is one reason why we need a more principles-based approach to regulation. Rules always grow loopholes.

5 comments so far | RSS Comments RSS

You’ve got to admire Mike Konczal for poring over all the legalese and finding the loophole.

Chapeau bas, Mr. Konczal!

Posted by EmilianoZ | Report as abusive

“…it defines “swap execution facility” so broadly that two traders talking on the telephone — just like they do in the current OTC market — can be considered such a thing.”
Not true, the two traders have to go through an intermediary , so “swap execution facility” applies to interdealer brokers and electronic platforms like (thomson-reuters) tradeweb, and not to two traders talking directly to each other on the phone.

Posted by alea | Report as abusive

Felix (& Mike): Isn’t it possible that many of these transactions really *cannot* be exchange traded or cleared? It’s my understanding that accounting rules require companies to match very closely the terms of the risk they’re exposed to with the instrument they’re using to hedge that exposure. The consequence of not doing so, as I understand it, is that the instrument must be marked to market on the company’s income statement, which no CFO ever wants to happen. So companies with very specific risks – and surely that includes most public companies – won’t be able to hedge with generic, exchange-traded derivatives products. That’s where banks, swaps dealers and these customized OTC instruments enter the scene. How are companies supposed to precisely hedge risks without them?

Posted by Norm43 | Report as abusive

Or perhaps we should scrap the regulation model entirely. It seems you’re coming around to the fact that all regulations/regulators are eventually circumvented.

Can we not use existing laws against misrepresentation, misallocation, fraud, etc to deal with these financial miscreants? I’d rather have these matters in the hands of judges than bureaucrats.

If you lie, cheat or steal, you go to jail. It’s pretty simple, really.

Posted by MattStiles | Report as abusive

Regulations are crafted to be circumvented by those who draft them. Regulators can be circumvented if they are greedy or lazy. The real crisis in America is one of character.

Posted by eddieblack | Report as abusive

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