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Progressives Fight Establishment On Spinning Off Swaps Desks

Blanche Lincoln’s derivatives bill included an item that would force big financial firms to spin off their swaps trading desks. While it’s unclear how in practice this would work – firms might be able to set up an affiliate trading desk and keep it under the same corporate roof – this could deny investment banks who set up lucrative trades from also benefiting from accessing the Federal Reserve’s discount window, FDIC deposit insurance and a host of other activities available to commercial banks. Needless to say, the banks, worried about losing a major revenue source, have made this their signature fight in financial reform, with lobbyists spending millions to keep the measure out of the final bill. Republican Senators have offered an amendment to strip this provision, but Democrats who would otherwise flip have been reticent, mindful of the political implications.

Among the establishment, Sheila Bair and now Paul Volcker have expressed their opposition to spinning off the trading desks, claiming that this would push derivatives trading into unregulated shadow markets. I don’t understand how this squares with the requirement that all derivatives be traded through a central clearinghouse or an exchange. But this has been the de rigeur defense from an establishment that probably wants to maintain the status quo and the profitability of the nation’s largest financial firms.

It’s heartening that we’re finally seeing some pushback on this. Economists Jane D’Arista and Gerald Epstein of the University of Massachusetts explain that spinning off the trading desks is as central to a modern-day conception of the Glass-Steagall Act as banning proprietary trading among commercial banks:

Chairman Bair’s concern was that forcing derivatives dealers out of banks would move the business into less regulated and more leveraged entities. While saying that banks should not engage in speculative activities, she argued that banks have an important role in creating markets for their customers while needing to hedge interest rate risks related to their core lending business. Chairman Volcker, too, took the position that providing derivatives is a normal part of a banking relationship with a customer and should not be prohibited.

These are assertions that need to be questioned. First, if banks’ role in selling derivatives is so important and if it is part of the usual course of a banking relationship, why is it that only five banks – J.P. Morgan Chase, Citibank, Bank of America, Goldman Sachs and Morgan Stanley – account for 90 percent of the market? Surely that kind of oligopolistic domination of the market makes clear that it is not an activity normally undertaken by banks. Moreover, the level of concentration among swaps dealers is, in itself, systemically risky in addition to being anti-competitive […]

Chairman Lincoln’s provisions have the enormous value of getting the vast dealing and trading operations in derivatives out of the shadowy off-balance sheet world where they are now posted by the large bank and investment bank dealers. This will have very substantial systemic benefits for the derivatives market and for the banking system as well. Moving the selling and trading of these instruments into separate entities will increase transparency by bringing derivatives out of the shadows so that dealers can be more easily regulated and the prices and volume of purchases and sales in the market will be readily available to counterparties. It will also ensure a better capitalized derivatives market since, as the crisis revealed, there is so little capital backing for the off-balance sheet liabilities of the large banks where the majority of the business is still being conducted. In addition, it will shrink the enormous exposure of a few very large banks that can threaten the stability of other financial institutions and the many non-financial companies that use this market.

A vote to maintain derivatives trading for the big banks – as the seller, not just as the buyer, which is of course allowable – is simply a vote for big bank profits. The clearing requirement for derivatives will ensure a safer set of transactions, and keeping this market worth hundreds of trillions of dollars out of the larger financial economy, where it intermingles with depositor money, is crucial to sustain a larger banking system.

There’s credible concern that this derivative trading desk piece is a bargaining chip, something that can be traded away to lobbyists to retain other parts of the bill. In fact, it may help the ban on proprietary trading in the Merkley-Levin amendment (which also would prohibit companies from taking the opposite side of a deal with investors for their own account) pass, with the finance lobby so tied up with profit protection.

In the aftermath of the Brown-Kaufman vote, at least there is one area where smart progressives are organizing to make meaningful changes to the Wall Street casino. Mike Konczal shares my belief that this won’t get done in one day or even one bill, but the building of an alternative to the neoliberal consensus of how the financial system should work is an important end in itself.

Will there be a cultural change, either on the regulatory side or the Wall Street side? Definitely not for the second, and we’ll see on the first. And will this simply be use returning to the financial sector of 2005-2007 with some additional regulatory powers? I certainly hope not, but we’ll see.

Here’s what I tell myself: it took 30 years to take apart the fragile financial regulations and norms the New Deal and the mid-century crew put together to create a financial sector that works to build a broad-based prosperity for everyone. We aren’t going to rebuild that overnight.

And therefore we have to keep working.

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David Dayen

David Dayen

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