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Scanning for Controversy in the Lincoln Proposal

Sen. Blanche Lincoln (D-Ark.) has released her language for the derivatives portion of the bill overhauling financial regulation. I’ve gone through the

Ceri Sinclair
News
Last updated: Jul 31, 2020 | Apr 17, 2010

Sen. Blanche Lincoln (D-Ark.) has released her language for the derivatives portion of the bill overhauling financial regulation. I’ve gone through the section-by-section report, and am now digging into the language more deeply. Bills are complicated things, and I’ll be looking more closely this afternoon. But here are some provisional impressions of major aspects of the regulatory reform.

**Swap desks spin-out? **

Among the more controversial provisions reportedly in the act was a proposal to make investment banks spin out their swap desks (a swap desk being the department of the bank that sets up the kind of derivatives contract, a swap — like a credit default swap — that is currently mostly unregulated and not traded on exchanges). Why? To make sure that banks would not speculate on the other side of their clients’ bets. The problem is, investors agree to make trade derivatives with banks because they believe the bank is stable and profitable enough to pay out, if need be — a tiny swap entity might not be, and it might discourage investors from making the deals at all. But I can’t find any language clearly stating that swap desks need to be spun out from financial institutions, lest they lose access to the Federal Reserve’s discount window or F.D.I.C. deposit insurance. I’ll keep looking.

The end user exemption

The bill does keep an “end user exemption,” meaning that non-financial companies — say, Caterpillar — looking to use derivatives to hedge against changes to prices or interest rates do not need to put derivatives deals through a clearinghouse. They can continue to make the deals over the counter with their investment banks, as before, if they choose.

Commercial end users are exempted from mandatory swap clearing. Such end users are defined by nature of their primary business activity. Financial entities may not claim this exemption. These end users can opt out of the clearing requirement for the swaps only if they are hedging commercial risk…

**High capital and margin requirements for OTC deals — for financial firms, but not end users

**

The bill calls for “capital and margin” — that is, the money an investor needs to post in a kind of escrow fund, just in case the derivative contract starts making losses — to be “significantly higher” for over-the-counter derivatives deals than for ones moving through clearinghouses. It seems to exempt non-financial firms from posing those higher rates of collateral.

Capital and margin must be set to ensure the safety and soundness of the Swap Dealer or Major Swap Participant and be set significantly higher for uncleared swaps as opposed to cleared swaps. Transactions are exempt from initial and variation margin requirements if one of the counterparties is not a Swap Dealer or Major Swap Participant.

No loophole for banks

The bill attempts to preclude banks from creating non-financial subsidiaries to act as end users, to avoid higher collateral and other requirements.

Affiliates of commercial end users may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent. Affiliates cannot use the parent’s exemption if they are themselves swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, issues that would be investment companies but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these entities.

If the CFTC sees abuses taking place, it can write rules to end it

The CFTC has the authority to write rules to prevent abuses of the clearing exemption.

Collateral does not have to be cash

Banks do not necessarily need to pose cash or stable, liquid investments like Treasuries as collateral. But the bill does not specify what counts as collateral.

The Prudential Regulator sets capital and margin for bank Swap Dealers and Major Swap Participants, and the CFTC sets capital and margin for non-bank Swap Dealers and Major Swap Participants. Capital and margin should be comparable under all regulators and set within 180 days of the date of enactment. Non-cash collateral is permitted but may be restricted by appropriate regulators.

Ceri Sinclair | I promote contact between clients, consumers, and companies in order to complete projects. I have over 10 years of experience in management consulting, team building, professional development, strategic execution, and business engagement in both the public and private sectors. I've worked on projects for TechPoint International, Cyberry, and Induster.

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