If you've been following my Twitter feed, you know that the Senate financial-reform bill passed cloture on a 60-40 vote, with three Republicans -- the two Maine senators and Massachusetts' Scott Brown -- crossing the aisle to bring the debate to a close. Two Democrats, Maria Cantwell and Russ Feingold, voted to continue debate because they feel their amendments to strengthen the bill deserve a vote.
However, one of the amendments that Cantwell has been stressing may not strengthen the bill at all -- it may in fact weaken it. Cantwell is proposing, along with Blanche Lincoln, to close an apparent loophole in the bill that was identified by Americans for Financial Reform.
As described in this article, critics say a loophole in the bill supposedly "does not prohibit the use of uncleared swaps and, even more egregious, expressly states that no swap can be voided for failure to clear." As regular readers know, clearing requirements are central to reforming the opaque derivatives market.
However, it looks like this argument is based on a misreading of the legislation. Obama administration officials who favor the legislation point out that there are in fact harsh punishments in the law for those who violate the clearing requirements: "It shall be a felony punishable by a fine of not more than $1,000,000 or imprisonment for not more than 10 years," according to the Commodity Exchange Act (CEA). That language doesn't appear in the current bill because it modifies what activities are restricted by the CEA; it does not change the penalties for violating the rules. Anyone who breaks this law is going to face some serious problems, including being banned from the industry.
Cantwell's amendment, however, doesn't address punishment. It addresses what happens to derivatives contracts that are found to be improperly avoiding clearance. Right now, despite the criminal penalties, these contracts are not made void. Cantwell's amendment would change the legislation so that any contract that should have been cleared but wasn't is nullified.
That might have unintended consequences, administration officials say. Swaps dealers selling derivatives to investors or end users will have a strong influence on whether a given deal is cleared or not. Voiding uncleared derivatives by statute could give these dealers an out in the case that they end up on the losing end of a derivatives deal. Administration officials worry that dealers on the wrong end of a contract -- potentially owing hundreds of millions or billions of dollars -- could simply claim they should have cleared the derivative and walk away, accepting the criminal penalty and fine but avoiding a potentially huge loss.
I'm waiting to see what Cantwell's staff thinks of these concerns, but this much is clear: The idea that there is no penalty in this law for uncleared derivatives is false. Whether voiding illegal derivatives contracts is a good idea remains to be seen, but it does seem like it gives an advantage to the most sophisticated market participants -- the big banks.
-- Tim Fernholz
