New Discount on Swaps: Section 106

Last week’s The Economist has a write-up on the new regulations that will eventually control the several trillions of dollars of notional amounts underlying the OTC derivatives that are currently being traded. Firstly, it seems that the political theatre that was the Goldman scandal had some effect:

The fraud charges filed against Goldman Sachs, over synthetic derivatives, emboldened those looking to crack down on exotic instruments. On April 21st the Senate’s Agriculture Committee—which oversees the Commodity Futures Trading Commission (CFTC)—passed a surprisingly draconian set of derivatives provisions. Elements of this will be offered as an amendment to the main bill. [link]

The main part of the bill on the table is Section 106 which will deny access to the Fed’s discount window to those banks that trade swaps. The Fed’s discount window, as some of you may know, is that part of the central bank that lends directly to banks. The discount rate (the lending rate from the discount window) is usually about 100 basis points above the Fed Funds rate, which is the bank-to-bank lending rate. When banks can’t find other banks to provide them with some cash, they go to the Fed. In times of crisis, the discount window proves to be quite useful, and that is why, over the last two years or so, the Fed decreased the spread between the discount rate and the Fed Funds rate to 50 basis points, and extended the lending period from overnight to 30 days, and then to 90 days.

Whether the section is a bargaining chip or not, denying access to the discount window, the article states, will send banks scurrying off to spawn non-bank subsidiaries that do trade swaps, so not sure if that will change anything apart from inconvenience them. However, the parties most hurt by this are those who actually use the derivatives for hedging risk, e.g., airlines to hedge against rises in jet fuel prices, also known as “end-users”:

Many of those end-users, which collectively hold 10-15% of OTC derivatives outstanding, also want exemptions from clearing. Without one, they argue, increased collateral requirements for cleared trades would make hedging their everyday risks much more expensive. As things stand, some commercial firms would get an exemption, while others—such as sweetmakers hedging against swings in sugar prices—would not. [link]

We shall see how this unfolds. Meanwhile, entrepreneurs looking to cash in on the new regulations – here’s your next business idea: Start a derivatives exchange.

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3 comments for “New Discount on Swaps: Section 106

  1. Aaron Russo
    May 5, 2010 at 8:27 pm

    Politicians drive me crazy. Leave it to congress to Monday morning quarterback a problem that won’t happen again for another 25 years anyway. What’s next stricter horse drawn carriage laws, telegraph taps? I think the more congress steps in to babysit us the more we come to rely on it. When in reality, if people knew what they were buying in the first place this wouldn’t have happened. The problem is in congress creating these unfair playing fields that the much more efficient and much quicker moving private industries can take advantage of. If congress rules out Fed borrowing banks trading derivatives than the much more clandestine and opaque hedge funds and money managers will show up to pick up the slack. And by the time congress figures out how to legislate those guys their damage will be done and the next guys will show up. Meanwhile no one learns any lessons, everyone in finance has more paperwork to fill out, and only people gaining jobs in the process are politicians. Bottom line, when I was ten years old my grandma used to play poker with me for dimes, she never felt bad for me and if she won she kept the money. The result was simple; I got a lot better at playing poker…

  2. May 12, 2010 at 5:53 am

    Sir, all due respect to the lessons learned from grandma, but the derivative market can hardly be likened to poker camp at her knee. The critical distinction one might consider here is between activities where gambling prowess or lack thereof results in the gambler’s own wallet getting thicker or thinner, versus. activities where the gambler’s entire community can be destroyed by his or her recklessness. Orange County anyone? Or better yet, AIG, Goldman Sachs and Morgan Stanley….

    The most fundamental lesson hopefully learned from the financial meltdown is that individual’s pursuing their own unfettered self-interest can actually inflict massive systemic harm on the economy (see “I was wrong” Greenspan testimony 10/08/2008). Case in point: AIG and credit default swaps. As an unregulated derivative, credit default swaps were/are kind of like having 13 people playing the same poker hand with out any of them having actually paid for their chips. When those 13 players are caught naked, their shorts shredded, we all got to see ugly that’s hard to expunge. (See 13 Bankers, 2010) When an unlimited number of people can take a position on the same underlying asset without any requirement to actually hold reserves to cover losses, the risks are no longer borne by the individual, they are borne by many. Tragedy of the commons becomes apocalypse of the commons with moral hazard on top thanks to bailouts rewarding the stupidity of it all.

    Markets operate somewhat efficiently only when there aren’t distortions in information necessary for valuation. Forcing credit default swaps (and other similar derivatives) to mark to market daily (as in the Futures market) would go a long way toward setting a foundation for a workable market.

    Are the current proposed regulations the best possible approach– absolutely not. By the time they come out of the lobbyist-besotted gristmill that is our legislation, I’m sure they will be toothless at best and, at worst, will probably lead to a range of unintended consequences beyond even what you predict.

    I would argue that almost in whole, the 1933 Glass-Steagall act should be re-instated. Separating speculative activities from consumer banking (one of the primary legislative solutions based on analysis on what caused the Great Depression) led to an unprecedented era of calm in U.S. financial markets. The 1999 Gramm-Leach-Biley act repeal of that act was, I believe, the inflection point that set in motion what we have now reaped, especially since, unfortunately, the world’s financial market followed our lead. What is being proposed is a pale shadow of what is needed. A partial solution here will be no solution at all, I fear.

  3. Aaron Russo
    May 13, 2010 at 12:40 pm

    I think we’re on the same side. I don’t think capitalism is a perfect system I do however think it’s the best one we have. There were some stupid greedy moves made in some high places, but any legislation at this point will be backward looking and as such very ineffective. Congress’s answer seems to be if it moves tax it, and if it stops moving subsidize it. The only losers here are the people who work and do business with the moving companies, and the tax payers of the ones that stop moving. And for all this we put into congress still doesn’t stop busts just changes their names ever few years. In this particular case, the companies all knew what was going on when it was happening but they let it continue because they knew the government wouldn’t let them fail. Chuck Prince the CEO of Citibank was asked in 2006 about the bubble in home lending and he said, “While the music keeps playing we’ll keep dancing.” This isn’t a man preparing for economic moves this is a man who is working around a slow moving inadequate government.

    The more we step in to protect each other from ourselves the more we will depend on it. However, if we let the tide go out sure we’ll see who’s swimming naked, and sure some big institutions might fail, but tomorrow the sun will come up. And the strong will survive and money will go to where it’s treated best, like always. We won’t just be writing off a bust today for another one in three years…

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