GearGrind: Regulators to Study Requiring Standardized Algorithmic Computer-based Models to Pinpoint Derivatives Risks

A little noticed provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law last week, calls for regulators to study the feasibility of requiring use of “standardized algorithmic descriptions for financial derivatives."

The provision requires a joint study by the Securities and Exchange Commission and the Commodity Futures Trading Commission that examines the viability of requiring “the derivatives industry to adopt standardized computer-readable algorithmic descriptions which may be used to describe complex and standardized financial derivatives."

"The algorithmic descriptions defined in the study shall be designed to facilitate computerized analysis of individual derivative contracts and to calculate net exposures to complex derivatives. The algorithmic descriptions shall be optimized for simultaneous use by - commercial users and traders of derivatives; derivative clearing houses, exchanges and electronic trading platforms; trade repositories and regulator investigations of market activities; and systemic risk regulators."

The provision, authored by Rep. Bill Foster (D-Ill.), a physicist and founder of a theater lighting company used by the Rolling Stones and Broadway touring shows, is nearly identical to Foster's original language which made it into the House's version of the financial reform bill, which passed Dec. 11.

When we interviewed Foster back then to try to understand more of what he or Congress was calling for in asking for such algorithmic, standard derivative models and measures, he said it was so that credit default swaps (CDSs) and other derivatives, most of which must be reported to databases to which regulators will have access (called "trade repositories" in the Dodd-Frank act), could be easily searched and analyzed by computers in an agreed-upon baseline, or standard way. The idea is that once the views of the market are centralized, there has to be an agreed-upon electronic method for measuring the risk within it. So firms can more precisely understand exactly where and at what level their exposures to derivatives augur further scrutiny or rejiggering, and the regulators can monitor more accurately the risk levels for these firms and the overall market by having the banks and other of the market's counterparties report their derivatives trades into the databases in a uniform way.

Foster confirmed today that the aforementioned conveys the gist of his provision, but in his own words added:

"Once the data of the market are centralized, there should be an agreed-upon electronic method for accessing that data so that each firm – and the regulators – can estimate the risk associated with different positions in the market."

Firms can also know better when to act to thwart trouble by knowing the risk standard to which they'll be held by regulators. The terms of many of these complex contracts can remain lost in the paper morass that has long been a congenital part of derivatives trading.

"In this bill there’s a mandate that all these complex OTC derivatives are stored in a trade repository," Foster said. "But if the trade repository consists of a big stack of legal contracts, it’s almost useless. Whereas if the trade repository consisted of a set of algorithmic descriptions the computers can rip through and say ‘hmm, this is interesting, through a series of complex derivatives, institution X was setting up a very strong position shorting institution Y.’ Then this is a very interesting question that can be reasonably asked, given the electronic form of these, by a regulator. It would be almost impossible to ask that question if you had to do it with a bunch of lawyers plowing through the individual legal clauses of a big stack of contracts. So this gives them a fighting chance of being able to plow through that."

Many custom-tailored derivatives and even a good number of contracts considered plain vanilla or generic are still executed using paper and/or the phone, which makes analyzing them effectively or efficiently impossible. Firms only recently began using email - also problematic because of its serial (one-by-one) unstructured peculiarity - to assign trades to third parties on transactions they desire to exit or take the opposite wager or position. This arcane and labyrinth nature, specifically in credit default swaps, is what precluded easy remedies during and after Lehman Brothers collapsed, and as AIG and Bear Stearns teetered toward bankruptcy and were ultimately rescued in government bailouts, when quick solutions – namely clearer views of these firms' large amounts of outstanding trading positions in derivatives – were direly needed.

The sheer volume of trades can make extremely difficult the task of tracking down all outstanding transactions to find out which of these contracts cancel (or perfectly or partially hedge) each other out - a process called "netting" - particularly when the instruments lack standardized electronic descriptions.

Also, valuing the derivatives has proven quite tough, especially when only a handful of banks - five currently - essentially control the market. Buy-side firms like hedge funds have grown to distrust both the "marks" - monetary values - the banks place on swaps these firms own, and the speed at which the banks are willing to be moved to change them, especially, these firms say, when the market moves against (financially decreases the worth of, or makes it expensive to hold) the banks' side of these transactions. It's often during times of stress or volatility when disputes erupt between counterparties over the worth of a credit default swap that one has bought from or sold to the other.

The CDS market lacks key standards and infrastructures like comprehensive trade repositories that would allow for better management of counterparty risk. There was unprecedented volatility in the credit default swaps market triggered by the bankruptcy of Lehman Brothers, the 158-year-old investment bank, and the rescue of AIG, the world's largest insurer. Besides spikes in trading of CDS linked to those firms, there were sizable increases in unwinds and novations, or trade assignments, of swaps for which Lehman or AIG were counterparties. Firms attempted en masse to cancel or reassign ("novate") derivatives contracts they had with either, both of which had been major players in the market - Lehman until Sept. 15, when it ceased to exist (but for its broker-dealer arm in the form of a swaps cleanup crew; Barclays a day later purchased the real estate of bankrupt Lehman's broker arm, and agreed to support some of its trading positions), and AIG until it began to unwind the operations of its swaps division in October 2008.

"If you look at the conversations I’ve had with the people that were trying to get something useful out of the carcass of AIG," Foster said, "they are forced to go through with their lawyers all the legal details of these very complicated derivatives contracts. And it’s a very expensive thing. And even when they’re trying to offload these assets, it’s very expensive even to get third parties to bid on them, because any third party that’s thinking of bidding on these, has to go through and have their lawyers plow through and figure out the true implications of all this and then stuff it into their valuation models to figure out what the fair value of these things are. So all of that would also be a much, much easier task if there was a standard electronic format, where you could potentially just give whoever was sitting on this big set of AIG trades, you could say ‘okay, here is the electronic description of all of these customized derivatives,’ and just send out that list of all of these derivatives contracts to all the big players who would be candidates to buy them. They could jam them into their valuation models and come up with a bid. Had this been in place at the time that we had to deal with the carcass of AIG, it would have made life much easier."

According to the act, regulators will also probe "the extent to which the algorithmic description, together with standardized and extensible legal definitions, may serve as the binding legal definition of derivative contracts. The study will examine the logistics of possible implementations of standardized algorithmic descriptions for derivatives contracts. The study shall be limited to electronic formats for exchange of derivative contract descriptions and will not contemplate disclosure of proprietary valuation models."

The SEC and CFTC are to coordinate the study with international regulators and financial institutions "as appropriate and practical," and submit a final written report of their findings by March 20 to the House agriculture and financial services committees; and the Senate agriculture and banking committees.

The CEO of an electronic platform that the big banks support in trading bonds and derivatives with buy-side firms like hedge and mutual funds said when we asked about the provision on background back in December that the bill seemed to be looking primarily to address and "demystify" the more tailored derivative contracts to make their risk components more transparent. "This particular effort appears to be more focused on the customized contracts, versus the standardized instruments like CDS indices and single-names that seem ripe for e-trading," the CEO said through a spokesperson.

Kevin McPartland, an analyst at Tabb Group, emailed us then that the provision seemed a plausible way to make the technical aspects of the derivatives market more uniform and contracts fungible, meaning interchangeable. But he said regulators should be careful to let the industry set those standards. (The "ISDA" he refers to below is the International Swaps and Derivatives Association, the main lobbying group for the market that sets derivatives standards. "FpML" refers to the Financial products Markup Language standards that make some derivatives contracts computer-readable by making the data fields included in those contracts uniform; the ISDA develops FpML standards, which are based on ISDA's template for derivatives contracts.)

"From a quick read, this feels like a lot of words to explain what is a very simple suggestion: To mandate a standard electronic format for all derivative contracts," he said. "For example, if you were to take the standard ISDA contract for a vanilla CDS and translate that into FpML or something similar, and require that all CDS transactions be stored in that format, this, in theory, would allow any trade done with any counterparty to be read and understood by any other market participant or regulators. Even for complex derivatives, all have a good handful of value [data] fields that exist no matter the complexity (such as cash flows, duration, etc.), so this is not a completely impossible idea.

"My concern however, is that Washington should not begin mandating the use of technology standards. Even in the tech industry, it is not the federal government that tells us how to send e-mails – market forces and industry groups set those rules. The same should be the case for Wall Street.

"If reporting of all OTC trades is mandated, as it likely will be, the process will require some level of automation to handle all the volume. That being the case, let the CFTC [and/or SEC] work with industry participants to agree on a standard electronic format."

Not all derivatives contracts are submitted to the Depository Trust and Clearing Corporation (DTCC), The Street's giant utility for processing and settling securities which runs a database for storing swap trades: The banks decide whether to put their OTC trades into DTCC's Deriv/SERV trade matching and confirmation system and its database - called the Trade Information Warehouse. (Deriv/SERV feeds the warehouse.) Therefore, not all swaps trades are housed or reported there. So claims that DTCC and the industry make of the various percentages of CDS or derivatives that are somehow electronically processed via DTCC do not refer to the whole swaps market; they actually refer to only the derivatives the banks consider "eligible," or decide to submit, to DTCC. So these numbers actually describe a subset of a subset of the market. It's important to remember that when reading the oft-repeated claim that DTCC processes "90 percent" of credit default swaps: That's 90 percent of the CDS the banks have decided to submit to DTCC.

MarkitSERV, a joint venture between DTCC and Markit, and the InternContinentalExchange's ICE Link, are each working on their own solutions (meant to be compatible) to make novations more automated, essentially by combining into one what used to be two steps - getting a counterparty to consent to a trade assignment as part of confirming the terms of the trade.

Regarding valuations, a credit default swaps pricing engine has been freely distributed by ISDA since early last year, after the industry was pushed to provide a method that could show some degree of objective analysis following the numerous disputes among counterparties over the worth of the contracts they held with one another. Whether the result - a bank-designed pricing engine - can truly be considered objective remains part of the debate over industry-applied standards.

Developed by JP Morgan Chase & Co., the model - now called the ISDA CDS Standard - was transferred to the trade group and made available for download in February 2009. Markit Group, a provider of credit swaps data and valuation services, acts as administrator for the engine. Markit released in March last year XML specifications for calculating standard interest rate curves based on fixed 1 percent and 5 percent coupons (interest) for generic credit default swaps that the industry decided to establish to make certain plain vanilla contracts more uniform and easier to trade or exchange.

The Street reckons that if its pricing model becomes the industry's baseline standard for valuing credit derivatives, it will limit disputes and cut down on trading and processing problems.

When asked about ISDA's standards, Foster called them "a very good starting point."

"For example," he said, "all of the legal boilerplate that they have that defines what it means to be this type of credit event - what exactly the rules are for deciding whether a credit default swap has been triggered or not: Those are key elements in the logical description of this that will remain useful. But what will be different and are different for these very customized and hard to understand credit default swaps is that there will be an algorithmic description of the logic behind them, which should allow firms to much more rapidly evaluate them, both those that are interested in making an open bid on these in the market, and secondly, for holders to understand their risk exposure."

An aside: All this talk of building more accurate derivative models reminds us of a package of stories we wrote on trading using university supercomputers and renting online retailer Amazon's spare computing power. For the former piece, we interviewed James Glimm, a distinguished professor and chair of the department of applied mathematics and statistics at Stony Brook University, based on Long Island and one of the intellectual ground zeros for quantitative finance. Glimm told us about a model Haipeng Xing, one of his colleagues in the school's computational finance department, was focused on building that could detect "change points," meaning a tool that could alert players to huge market cataclysms - rare "black swan" events or implosions - as they're first happening - when all asset values are appearing to become correlated and beginning to drop regardless of description, before the whole market plummets, or falls off a cliff.

"A change point means that you have a break with the past," Glimm said. "So an example would be a breaking bubble. In fact in finance, the major surprises are negative. The good news comes in dribs and drabs and the bad news comes on Friday afternoon. So what happens when you have some big change… is that you have all these random variables and normally they’re independent… and so you can spread your risk around – you buy a little bit of one and you buy a little bit of the other and you sort of say, ‘well if one goes up, the other will go down and so I’ve covered my risk.’ Now, when something happens, when you have a change point, everything’s correlated – you have a little bit of this, a little bit of that – but they’re all going to behave in tandem, and that’s the nature of a crisis. He has a model, and since it’s a general model, it can’t predict precisely when, [but] the idea is to have it predict when the volatility is likely to have a jump.

"You want to get your return without the risk," Glimm continued. "You want to be risk neutral but get a positive, high return. That’s sort of the use of the Black-Scholes strategy," an option pricing model that has been used to predict market direction, but that has been shown to fail to take into account the risks of large, market-moving events.

"What goes wrong is that the volatility normally fluctuates around a little bit - it doesn’t change too much - but it can have huge jumps," Glimm explained. "So it can sort of double overnight. Like if Greece defaults on their bonds, and then all of a sudden everyone goes into a panic. Volatility jumps and so it’s called a change point. So you have all of your models and they’re suddenly wrong. So [Xing’s] developing a theory which will detect the change point as it’s in the process of happening, so you don’t have to wait until you’re broke to discover your portfolio is worthless; while there’s still a chance to get in there, he will have a model that says ‘hey, something’s happened, we better go to plan B.’ One might spot it as it’s happening with these theories so that you could at least have a bit more of a rapid response."

All of which we were reminded of this Sunday while laying about reading the "Economics focus" section of the latest issue of The Economist, which describes central bank economists, policy experts and computer scientists putting their heads together to build unconventional "agent-based models" that could detect early the next financial crisis. These models differ in that agent-based models make no assumptions that markets are efficient or always adhere to a narrow band of "normality" or "equilibrium," whereas conventional models do: The last crisis pointed out the serious flaws in said presumptions, which are held by what's called the "efficient market hypothesis," which basically makes no room in its calculations for steep downturns. Essentially, conventional models can't account for crashes because they don't see them. They can't because they aren't made to look for them. Whereas agent-based models replicate reality better by sending out "agents" ("simulations" for simplicity) that independently interact with one another and whose reactions can be proportionally larger than the cause that triggered them, just as they are in real life panics or in the "herding" behavior exhibited by investors under stress, or in responding to some market bias that, like a giant Russian doll, can be built up and gain in popularity or volume to become conventional wisdom that falls over and rolls in one destructive direction, flattening everything. The Economist says Bank of England's Sujit Kapadia is trying to model the complex derivatives market and the interconnectivity of its participants to shore up the weak links in this web.

All these calls for better models seem to us to naturally stimulate rewarding business opportunities for anyone smart and innovative enough to tinker toward real solutions. So whiz-bang: Go get at it!

One of the most interesting responses to Foster's call for assessing ways to standardize methods of determining derivatives exposure came from Dr. Andreas Binder, managing director at MathConsult, a Linz, Austria-based firm that develops and sells derivatives pricing and risk analysis software. Binder pointed out the challenges in finding a baseline tool for assessing exposures to instruments as complex as derivatives, particularly if the goal is to uncover the potentially risky correlations between all of them. Doing so is complicated by the fact that just a single derivative includes multiple variables that can be impacted by a number of fluctuating circumstances, such as changing interest rates or a company's ability to pay down debt, all of which needs to be understood, or modeled, accurately.

A derivative may itself be comprised of several other derivatives, the terms of which can be customized, like in the case of a "swaption," which is a swap on an option, or a "callable inverse snowball," an exotic instrument with two funding legs, or payment streams, which requires computation of past coupon (interest) rates with whatever the current, floating rates are.

Binder's mention below of a "copula trap" refers to the conundrum that measuring complex instruments accurately requires inclusion of myriad variables, yet because one must control for the volume of those variables to make the measurement practical, doing so may preclude the assessment of too many interactions, or precisely those interactions needing to be examined for the analysis to be close to accurate, while including too many could result in "noisy," or inaccurate, results as well. Many analysts, in fact, blame The Street's nearly wholesale adoption of what's known as the "Gaussian copula function" for creating the credit crisis, because it assessed default risk in mortgages by using the prices of credit default swaps which had only been around in number since the housing boom began its rise, and therefore were wildly inaccurate measures of that market's risk.

"In market risk, there is some standardization by exchanges or – in the case of OTC swaps – by ISDA. However, the standardization of swaps does not mean that the term sheets under such standardized schemes are easy to value and that their risks are easy to assess.

“In the credit market, there is some standardization for single name CDSs and probably also for CDOs [collateralized debt obligations; see definition below], but there is no central evidence on the nested papers of papers of papers lying in special vehicles.

“As I understand, the Dodd-Frank Act aims to install such a central database. If this database was installed, I am not completely convinced that a) you would obtain a transparent view on the market, and b) that any fantastic supercomputer would be able to tell you all the nested positions of market participants in such papers.

“Mathematically speaking, the difficulty of [measuring risks of] multi-name, credit-linked instruments lies in correlation," Binder explained. "For assessing the various influences of derivative positions, this magic computer has somehow to calculate numbers by assuming a model for the various influences [on derivatives' prices and risk exposures]. Depending on the assumptions of such a model, it will deliver different numbers. So, in order to avoid the copula trap, almost everything would have to be forbidden, which, from my point of view, is no solution."

We sent queries to a bevy of derivatives vendors - including Andrew Kalotay, FinCAD, Markit, Numerix, Pricing Partners, Quantifi Solutions, SciComp, SuperDerivatives, Icap's Trioptima and MathConsult - to see if they sniffed any business opportunities that might emanate from the regulators' feasibility study on creating a standard derivatives description and baseline measure of net derivatives exposure. So far, besides MathConsult, just Andrew Kalotay, Quantifi and Superderivatives emailed us back, although Superderivatives has yet to provide responses after saying it would.

Such efforts reside "outside our core domain," Kalotay said through a spokesman.

Quantifi said through a spokeswoman that market forces were already taking care of developing that which might be required from the results of the study. Such work, she said, includes the industry upgrading FpML, the adopted standards that make some derivatives contracts computer-readable by making the data fields included in those contracts uniform. The industry work, she said, also includes the recent proposal from the SEC that would require the conversion into electronic descriptions any paper-based details of the terms of loan payment streams for which bonds like mortgage-backed securities collect and are made up of, so each payment stream specification, or contractual provisions on said cash flows, would be downloadable into Python, a computer-readable programming language. The "waterfall" she refers to below is the structure determining which bond investors are paid first, based on receipt of loan payments that make up the bond.

"I’m not sure we have much to say on this," said the Quantifi spokeswoman. "The reason being is that the market is already looking at a solution for algorithmic description (which is different from algorithmic valuation – the bill is focused on description). There’s FpML obviously and then there is the recently proposed Python-based waterfall descriptions for collateralized contracts. Since the market is already looking at this and may choose to operate more electronically even without government intervention, Quantifi is participating in industry-wide efforts but isn’t necessarily pursuing this as a dedicated 'business opportunity,' but instead, treating it as an industry development as it would anything else."

Definitions:

A collateralized debt obligation, or "CDO," is a type of asset-backed security, or "ABS." An ABS is a pool of individual loans that can include mortgages or auto loans or credit card debt, which is packaged into a bond and sold to investors. An ABS comprised of mortgages is often called a mortgage-backed security, or "MBS." A CDO pools together any of these or other types of debt, loans or other bonds, the tranches, or pieces of which have different risks and maturities associated with them. Think of it as an "ABS of an ABS."

Credit default swaps are often described as being like insurance, but they are also instruments enabling firms to bet against, or "short" particular debts, when the belief is that a certain bond or debt is overvalued or headed for default. Some firms use them to hedge bonds they own against default, others to bet the bonds' value will sink. One need not own the bonds to which the swaps are linked to short, or bet against them. Critics say the latter, often referred to as "naked CDS," is comparable to buying insurance on another person's property or life, which is illegal due to the perverse incentives it can create in those so inclined to seek the destruction of said person's house or life, for money. Credit default swaps are insurance or shorts linked to the value of bonds issued by corporations; governments, from nations to municipalities; mortgage lenders; credit card issuers; auto lenders. Conceivably, CDS can be linked to any bonds or debt. With CDS, one often hears about the "spread," which represents the risk of the debtor defaulting on its obligations to pay back what it owes or what it was lent. That risk is measured or made tangible by being converted into a fee: The spread determines the annual fees, much like an insurance premium, a swap buyer must pay to the seller, which functions much like an insurer. The deal requires the seller to make a lump payout to the buyer if the debtor goes bankrupt, or if the debtor fails to pay on time what it owes. (Or in the case of "pay-as-you-go" mortgage CDS, the seller must make incremental payouts on each loan on which a homeowner defaults or fails to pay.) It also requires the seller to post collateral (make payments) to the buyer if the risk of default of the bonds underlying the CDS rises. The greater the risk grows of default on the bonds linked to the CDS, the more the CDS is worth, to the buyer betting against or "insuring" the debt; and the more costly it becomes for the seller. Vice versa if the debt's default risk decreases: The CDS becomes more valuable for the seller as the debt "being insured" or shorted is deemed safer, which ramps up the cost of "insurance" or "the short" for the buyer. Yet, buyers of CDS can potentially make money several ways: By selling CDS after their value rises to parties needing to cover their exposure to the troubled debtor involved, by receiving collateral from the CDS seller as the risk of default on the underlying debt rises, and/or receiving from the CDS seller a lump or incremental payout (like an insurance settlement) to cover the default of the bonds if they totally tank. The value of those payouts sellers must make to buyers - the insured or shorted amount - is often in quantities much larger than the sum of fees the buyer pays to the seller to hedge (insure) or short (bet against) the debt the swap references. However, most speculators cash out by selling CDS to others needing the protection, because waiting for defaults poses counterparty risk: that the seller could at any time become financially unable to make the lump or incremental payment or post collateral.

Sinon IV: Does the financial reform law threaten to empower lobbyists to weaken the 'fiduciary' standard of customer care for every investor?

The Dodd-Frank Wall Street Reform and Consumer Protection Act appears to open the doors for the Securities and Exchange Commission (and those that lobby them) to gut or weaken the "fiduciary" standard for everyone, essentially by being told to reexamine the whole notion, or definition, of the standard of customer care that's been applied under the Investment Advisers Act of 1940 and in the courts.

"Fiduciary duty" essentially means always acting in the best interests of customers, something which registered investment advisers (RIAs) are required by regulation to do, but brokers are not.

While the act asks the commission to probe the opposite of the following question, it also asks the SEC to study whether "the regulation and oversight of brokers and dealers provide greater protection to retail customers than the regulation and oversight of investment advisers." (And yes, vice versa, as we said prior.) Regardless, look for the industry to be all over the SEC to convince them oversight of brokers and dealers is stronger, which if they're successful, could serve to undercut the notion that the fiduciary standard of customer care as applied to RIAs - or anyone - serves to optimally protect investors, when an existing or nuanced alternative, they might argue, could supply what they also might call equal, or better, protection.

Sure, The Street loses that argument as long as the customer care standards on the books continue to be legally interpreted as they have been, and they are quite simply stronger as written for RIAs than those facing the broker-dealers: "Fiduciary duty" means that RIAs must show continual loyalty to a customer's best interests; brokers need only show "suitability" when advising clients, meaning deem the products they're selling to customers are appropriate in each case to each type of investor buying them.

Yet, if regulators are reexamining the entire value, and hence the strength and therefore the merits of these different standards of customer protections for RIAs and broker-dealers, particularly when the act also asks regulators to study whether essentially to "harmonize" these rules covering investor advising might be beneficial, the regulators' conclusions from the study can easily be used to change the level of customer care protections, and how they're applied, to any and all concerned. Whether they will, we don't yet know. However, we advise those concerned with advisor regulation or investor protection to watch the process closely as it unfolds: The SEC has to submit its report on advisors' customer care standards by Jan. 20, but must seek public comments in the meantime to complete its analyses and to inform the report.

Background: Unlike registered investment advisers (RIAs), brokers do not, nor have they ever, been required by regulation to have a "fiduciary duty," meaning act in the their clients' best interests. Nor have brokers necessarily been made to disclose conflicts of interest they may have in advising investors about a certain security available for purchase. The Investment Advisers Act of 1940 provided the exemption and laid the foundation for the practice; the SEC tried and failed to make the broker exemption to fiduciary more explicit in fee-based accounts in 1999. The Financial Planners Association sued the SEC over the exemption and won on appeal in 2007, a case that would seem to have barred what was a more explicit broker exemption to fiduciary standards than that of the 1940 Act. Yet in practice, fiduciary-exempted broker advising, long the norm, continued and remains.

The brokers, however, while it may seem counterintuitive, could find allies in weakening the definition or application of customer care in RIAs. If they do, the fiduciary duty could easily be weakened overall in how it's applied, especially if the SEC decides to harmonize customer care standards as the act essentially asks it to examine doing, among brokers and RIAs.

Note again that brokers are able under long-standing regulations to market products to investors under a lower customer care standard than RIAs. Thus it could be argued that brokers have a sales edge in moving their products, because they can engage in more "salesmanship" - meaning they can push their products harder, without fiduciary duty, meaning with less concern or less care for their customers' best interests - under the rules, than RIAs, which is at least in part why the RIAs have found the different regulatory requirements for standards of customer care unfair. While RIAs can claim they take the higher road, meaning apply the higher standard of taking clients' best interests into account, selling products is more difficult under such an onus, because sales under such a fiduciary filter is harder than requiring mere suitability, in which the brokers need only prove the products they're recommending to clients are appropriate for the type of customer with which they're dealing.

However, it's important to note that RIAs may find more value in remaining held to the higher standard of customer care. Plus, teaming with brokers risks zapping the credibility or level of trust RIAs have managed to build with the investors who actually know the difference between fiduciary duty and suitability, in required customer care levels between RIAs and brokers, even though many customers do not, according to studies including an oft-pointed to SEC-sponsored report by the Rand Corporation.

Time, per usual, will tell.

But know the act also preemptively weakens the SEC's ability to apply fiduciary duty in its full legal strength on brokers, as it precludes them from having any ongoing duties of "loyalty" to their customers in putting said customers' interests ahead of their own after giving said customers investment advice. It's a once-in, once-out, conversation-by-conversation (or transaction-by-transaction) deal if the SEC ever decides post-study to mandate it. This may become important to anyone whose broker manages as well as advises their investments. The fiduciary duty to which RIAs are held to requires they maintain an ongoing "loyalty" to their customers; to essentially always act in their best interests.

And regarding any rules covering brokers' conflicts of interest or "prohibited transactions," should the SEC decide to promulgate them post-study, the act says any material conflicts of interest shall be disclosed but "may be consented to by the customer." And, the rules' standard of conduct "shall be no less stringent than the standard applicable to investment advisers" when providing personalized investment advice about securities, but only under the first two provisions of section 206 of the Investment Advisers Act of 1940, which say no "device" should be employed or transaction done to commit fraud. So Congress, by leaving out the two other provisions in the prohibited transactions section - one which bans engaging in "any act" considered "fraudulent, deceptive, or manipulative," and another, which mandates disclosure of any trading that poses a conflict with a customer's trading (or money management) - means any rule the SEC may decide post-study applied to brokers, could in fact be less stringent than that applied to RIAs.

Further background: Congress chose to proceed with a modified iteration of the weaker Senate version of the broker fiduciary proposal. The compromise would call for a year-long study by the Securities and Exchange Commission to determine whether requiring a fiduciary duty for brokers when giving investing advice to retail investors is appropriate. The SEC would be empowered to promulgate rules if moved by the study to do so, but proponents for establishing such a requirement complain the study will lead to naught.

Sinon III: Does the "commercial end-user" loophole exempting non-financial corporations from derivatives rules pave the way for a new, risky market?

2.) Derivatives for everyone!!!

Why the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (formerly the ‘‘Restoring American Financial Stability Act of 2010") will be REALLY AWESOME for The Street and why government will always be The Street's BFF:

It might be wise to counsel corporations big and small to prepare themselves for what could be a “hard sell” onslaught in the form of vigorous sales pitches from banks to “commercial end-users,” meaning companies not generally viewed as financial institutions, to buy "over-the-counter" ("OTC) derivatives like credit default swaps, after Congress essentially carved out just such a growth opportunity for the big banks, which dominate sales of these instruments.

It seems logical, as "corporates," as they're often called, are the least tapped customer segment for these derivatives, and now the niche that looks to be the least regulated. And therefore easier to sell. If regulations that require financial firms to set aside more money to protect from potential losses on swaps trades curb at all what's been exponential growth of unregulated swaps trading between financial firms, sales efforts could easily be partially refocused on markets that will remain free of such restrictions going ahead. Look out end-users!

This of course discounts the rise in "headline" risk involved in selling derivatives these days, and it presumes The Street won't be chastened by it, particularly if some of the same swaps that led to AIG's $182 billion bailout, and those that made the mop up of Lehman Brother's such a blinding headache, are viewed as being "hard sold" to companies not predominantly financial by nature.

And we're also not sure the exemptions portend a danger that industrial manufacturing or corporate financing arms could be the weak hinges that lead to the next economic breakdown, getting not just themselves but others (if not everyone) in trouble from speculating on the markets using derivatives, if said financing is done out of the purview of regulators reminded in the bill they're our economy's risk-monitors, despite their nearly zero past success rate at flagging crises or stemming them: The money such end-user corporations play with may prove too little to trigger damage much beyond their own firms. But that doesn't mean others aren't questioning whether the danger isn't real or that the latter notion suffers from overconfidence that if such threats materialize, they can be isolated or contained. We've been through so much after all, where everything spread like wildfire! So is it really that outlandish to envision a supply chain derivatives-lit scorcher that could leave a smoking hulk of more than one industry? Particularly when there's no real measure available to determine to any satisfying or reasonable degree of certainty, whether the derivatives trades these firms are doing are done solely to mitigate real risks engendered directly from running their businesses - and therefore in compliance with the collateral exemption in the bill - or if the trades are essentially speculative, in which case the firms are supposed to post collateral, as the bill requires financial backstops for such derivatives bets? Is there, or is there not a danger for derivatives foibles among end-users when there's essentially no way to tell whether they are speculating, or if they are attempting to reduce risk when trading derivatives? Studies show derivatives use among corporate treasuries rising with some transactions involving speculative betting; data from the Bank of International Settlements shows non-financial “corporates" held record amounts - $1.6 trillion - of credit default swaps last year (see "Endnote Data" at the bottom of this post).

And while the bill forces banks to make "reasonable efforts" at working in the best interests of "special entities" when advising on swap derivative purchases - defined in the bill as including federal and state agencies; cities, counties and municipalities; as well as any employee or government benefit plan and any endowment or tax-exempt non-profit or charitable fund - there's nothing in the bill making the banks strive to reasonably meet the best interests of for-profit corporations when advising them on swap deals. (Big banks, through their brokerage arms, in fact, have never been made by regulations, nor are they made in this bill, to act in the best interests of any private sector customers, whether they're big mutual funds or individual investors. Although language in the House's version of the bill would have mandated 'best interests' dealings when brokers advise individual investors, Congress responded to industry pressure to keep the weaker Senate provision in the final bill, which asks the Securities and Exchange Commission to study whether to mandate such "fiduciary duty" - to make the brokers put their customers' interests ahead of their own - but only in dealings with "retail" customers, i.e. individual investors, but NOT big mutual funds or corporate institutions.)

And, to wit. The Street is a bold bunch. And memories are short. Here for instance, is Jamie Dimon, chairman and chief executive of J.P. Morgan Chase speaking today to the New York Times, after announcing $4.8 billion in profits the bank made in the second quarter, about how banks will be passing off the costs of financial reform on to their customers:

"If you’re a restaurant and you can’t charge for the soda, you’re going to charge more for the burger."

Okay then. I'm not sure that was the finest of moments in the annals of PR. Logical though. We of course leave it to you to decide whether such methods are ruthless or prudent. Customer care issues aside. Regardless, at least according to how the story was structured, Dimon ended up there at the burger bar after saying generally that swaps regulation would not hit banks' bottom lines much (can you discern the uproarious screams of "Victory!" burning white-hot in the brains of every financial lobbyist on K Street?), though, he added, it would probably have "some effect on revenues and margins and volumes." What he meant by "some" is hard to tell. More better? Not so good? Does it augur ticking up more "commercial end-user" sales? Dunno.

Speculation aside, the Senate voted today to end debate on the financial reform bill. President Obama could sign it into law next week. And end-users will remain unregulated participants in the swaps markets if he does. [Update: He did, on July 21.]

The politicos, in their final agreement on the bill, may have indeed paved the way to make what has historically been the smallest market for banks' derivatives sales - derivatives sold to corporations - bigger and much more lucrative, essentially by exempting these so-called “commercial end-users” in the bill from having to put up collateral (pledge cash to protect from potential losses) on derivatives trades. This, as long as the firms using these derivatives are doing so to mitigate, or “hedge” risks they say they have in operating their companies, versus using the instruments to purely speculate for profit (or loss).

(But first an aside, to make certain things clear: What was an alleged "outcry" from end-users demanding they be exempt from derivatives rules, seems to some a bit disingenuous. Only after having acquiesced to lobbying pressure from the industry did these end-users go up to Capital Hill to tell everyone how much they loved derivatives and demand Congress NOT make it more costly for them to trade by forcing them to post collateral, even though many say collateral is essentially priced into these firms' trades by the banks, which require initial margin to protect themselves from potential trouble, with these firms. Such non-financial companies that trade swaps are mostly big multi-national corporations, although the industry lobby would have you believe endeavors as sweet and wholesome as that of your local baker do too. And they'd be right if by "bakeries" they meant behemoths like General Mills, which made $14.7 billion in revenue last fiscal year, versus the inference they hoped we'd make, which was that the nice paunchy fella with flour on his apron who before he was rendered antique or run out of business by our giant donut and coffee chains, personally made, displayed and served us our donuts and coffee in the morning - that THAT guy, traded interest rate or credit default swaps to keep his business running. Well, maybe he should have! Now, he can! Thank you Congress! Beneath all the condescension, some say the real desire among some end-users and their banks is to keep low-cost and quiet what's known as the "derivatives accounting game," involving using derivatives to mask debt or avoid taxes. Anyway...)

Also, according to the bill, none of these derivatives trades bought to mitigate risk or "hedge" involving end-users will have to be sent to central clearinghouses - mechanisms which act like the hub of a spoked wheel of a trading market; they're aimed at preventing trade failures, clearing bottlenecks and protecting against default among participants so such failures don't impair the overall system.

Neither will many swaps traded between financial institutions have to be cleared, by the way, including, regulators have said previously, those tied to mortgages, which, The Street contends, are just too customized to be cleared, even though none other than Stephen Cecchetti, the head of the monetary and economic department of the Bank of International Settlements, the primary organization that brings together each of the world's central banks to set capital requirements and credit standards, opines that these and all derivatives, for that matter, can be cleared. And, he says, they should be: All one has to do, according to Cecchetti, is employ a standard trade agreement (a securities contract) that's similar enough in its components to be fungible (meaning easily interchanged or traded for other swaps contracts) to some degree, yet flexible enough to offer choice in structure or terms, such as in maturity (meaning the years until the contract expires or pays out).

BIS' Cecchetti admits that trimming the amount traders can customize their derivatives will lessen the ability for firms to seek to put on so-called "perfect hedges," meaning trades customized for big payouts based on a set of very specific terms or set of occurrences, or to protect from losses on bets the firm placed that the exact opposite set of specific potential outcomes will happen. But it's also well-known that such "perfect hedges" can also have "perfect" downsides. In other words, highly customized bets gone wrong can go highly wrong; such wagers can essentially become cash succubi, or financial black holes that zap one's available or reserve funds. So, Cecchetti reasons, if standardizing derivative contract terms can be done without thwarting much of the flexibility in trades or betting, why not do that and centrally clear them, to protect against the kind of calamity keeping such wagers unregulated might enable, as the effects of such a cataclysm could far outweigh, or wipe out in a single sweep, financial gains made from custom unregulated bets? Plus, if one can simply make up or "synthetically manufacture" the bonds to which some derivatives are linked, Cecchetti essentially asks, why can't we just standardize the terms of the derivatives contracts themselves, because isn't the customization and creativity already present or endemic in the made-up bonds? He advises that total standardization is at least worth exploring as a rather painless method that could both better protect the system from outsized blowouts stemming from bad credit bets, while still enabling innovative trading solutions and choice in hedging risk.

Regardless, credit default swaps (often shortened to "CDS") linked to mortgages will not be centrally cleared - as long as the views of regulators who have concurred with the banks' views and said they won't be cleared, win out - even though AIG's sales of these unhedged swaps are precisely what led AIG hat in hand to a government bailout costing U.S. taxpayers a cool $182 billion - $62.1 billion of which the government paid AIG's counterparty banks in full for credit default swaps AIG had sold the banks, meaning our Treasury Department and the New York Fed decided not to press for any discounts on these trades that would have lessened the bill for us. The prudence in regulators doing so, particularly the claims that it was necessary to honor these trades to help prevent systemic collapse of the financial markets, is now hotly disputed, particularly by those who render it a backdoor bailout from citizens to the big banks for their own risk management failures for which the banks neither wanted to pay nor own up to. A good deal for them. Whether it's a good deal for us remains to be seen: AIG is still exposed to swaps and still paying out trades.

AIG's appallingly incorrect gamble of going long on the mortgage market when it was crumbling was essentially all-in, meaning there wasn't nearly enough collateral, nor opposite bets (mortgage-linked shorts) on AIG's books - some analysts say the firm literally had no hedges, that they had only sold CDS - that otherwise could have covered the insurance firm's outsized, overhanging all-mortgages-are-awesome fool's wager: So it was fucked. A gargantuan failure of risk management that was perhaps financial history's worst. But it was also incompetent risk management by the banks too, say some observers, if we're to believe the banks' and the government's claims of how direly important it was to honor the banks' CDS trades with AIG: The banks, these people say, didn't properly take into account counterparty risk - the potential that AIG might not be able to honor its myriad trading obligations if it came under financial pressure: They had to know AIG was considerably long on mortgages, because they all went to AIG to sell or buy mortgage-linked swaps, as well as other CDS. And so, some have asked, when counterparty risk is one of the most basic types of financial risks from which banks must daily consider and protect themselves, why are the taxpayers made to be on the hook, when it wasn't the taxpayers' fault, it was the banks' fault that the banks didn't properly protect from a disaster triggered from a counterparty risk that materialized? Yet, we paid. We in fact paid the highest price possible - 100 cents on the dollar - for said mess. Oh, and you're welcome. I guess.

Anyway, politeness aside, the clearinghouse: The hub of a spoked wheel of a trading market:

Clearinghouses otherwise step in between counterparties’ trades to “clear” them, or ensure each has the correct terms and enough funds so a smooth and accurate exchange of monies for securities – settlement - can occur. Doing so, clearinghouses are said to mitigate risks to the whole trading market or system involved, as well as protect the trading counterparties within the structure, by pooling and centralizing funds from all participants, monies that are aimed at backstopping the system via paying or making surviving firms whole if one (or several) of the system's major players stumbles financially and fails to meet its obligations; such a failure can threaten to financially hobble the faltering firm's counterparties too (though it doesn't follow that it always does or will), potentially (but not necessarily) triggering contagion where domino-like bankruptcies occur that could rupture the whole market. Central clearinghouses are purposed to lessen that risk; and big financial firms are required by the financial reform bill to send what looks to be their most generic, or "plain vanilla" swaps trades to these central clearinghouses.

In comparison, many stocks traded on exchanges which provide public prices are centrally cleared and long have been. I say "many," instead of "most," because some equities are traded in private so-called "dark pools" and/or are cleared bi-laterally, between a broker and some other counterparty like a hedge fund, another brokerage, or money manager, but no one knows how many because there are no requirements to report such trades. Such stock transactions are referred to in the industry as "ex-cleared trades." Regardless, stock trading is still considered the most transparent market, in which prices are generally publicly available, updated in milliseconds and the bids and offers of buyers and sellers are more often than not electronically matched (traded). Derivatives like credit default swaps, on the other hand, are all traded bilaterally, mostly over the phone and over-the-counter, or off-exchange, and are considered among the most opaque markets; five big banks - Bank of America, Citigroup, Goldman Sachs, J.P. Morgan Chase and Morgan Stanley - control 97 percent of the derivatives market. If you have a CDS price quote you have one from one of them. The InterContinentalExchange's Ice Trust has overwhelmingly dominated central clearing of credit default swaps since the big banks bankrolled its March 9 launch (note: the banks sold to Ice their stakes in an entity, The Clearing Corporation, they had agreed to back to clear CDS in exchange for a 50-percent share of profits of what that entity became, which is Ice Trust). Markit, owned by the big banks, is the sector's pricing and data provider; it operates the sector's well-known and most traded benchmark CDS indices, which account for about half of all CDS volume. The government began a probe a year ago into whether Markit or its bank-owners have run afoul of antitrust laws by dint of the banks being Markit's main data providers, reasoning that the banks could be advantaging themselves over customers on pricing, via Markit. According to Bloomberg, the investigation also concerns whether Markit has made use of its indexes by an unnamed clearinghouse contingent on the clearinghouse ensuring that any trades submitted for clearing include the banks as counterparties. Critics contend such structures represent oligopolies of CDS trading, products and data; The Street counters that they do not, that they're the franchises we built, and that the market can't exist without them, or us: It's the infrastructure that we, the banks, created. Plus the sector's players need to be well-capitalized enough - like us the big banks, they argue - to sufficiently lower the chances of too many participants getting fatally clobbered from playing what can be a high-risk game.

While some say requiring central clearing for vanilla swaps traded between financial institutions will consolidate great risk on the clearinghouses themselves, most agree that centralized clearing at least provides better views of both specific and overall risks for whatever market's being centrally cleared, and engenders a more easily moderated system than does bi-lateral trading. To view and mitigate overall risk in the latter model, one would have to puzzle together every interaction occurring among every counterparty in the market serially, or one-by-one. Difficult, if not impossible.

(Note: There is nothing in the final bill mandating that swaps be traded over an exchange or "swap execution facility." Rather, such trading would only occur of its own accord: That is, if an exchange or swap execution facility decides to list or make available any cleared swaps for trading, then those most generic swaps that clearinghouses decide to clear, can be traded over an exchange or swap execution facility. It's a rule that isn't a rule. The term "swap execution facility" is vague, but the bill basically says such a system must include multiple participants. According to the banks, that means trading with a single bank complies with the definition of "swap execution facility." The longstanding method whereby transactions are completed over the phone also fits the description of "swap execution facility," meaning any such trades need not be done electronically, or executed using only the computer screen. Given all that, there is technically no trading requirement: While it's understood that if whatever swaps any one of the platforms that registers to become a "swap execution facility" chooses to offer would become required to trade over any said facility (or exchange), whether it be that of a "single-dealer" system at one of the banks; systems of the the inter-dealer brokers, which are firms that broker CDS trades between the big banks, using mostly the phone; or platforms offered by the multi-bank-to-institutional-investors [e.g., Fidelity is an institutional investor] - the way those swaps are traded will not have to change. That's because they're still allowed to trade over the phone as the majority of swaps always have, or via an offering of a single bank. Plus, the types of swaps any one of these outfits may offer will be heavily influenced by their biggest customers, those of the inter-dealer platforms and the multi-dealer systems: The banks. Some of those banks own stakes in these systems, including multi-bank-to-institutional platforms Tradeweb and MarketAxess. Such firms depend on the banks for their livelihoods - the banks are the main suppliers of both their products and their profits. Therefore, they will not risk losing the banks that keep them afloat by offering anything the banks don't want them to.)

What are swaps?

Credit default swaps are often described as being like insurance, but they are also instruments enabling firms to bet against, or "short" particular debts, when the belief is that a certain bond or debt is overvalued or headed for default. Some firms use them to hedge bonds they own against default, others to bet the bonds' value will sink. One need not own the bonds to which the swaps are linked to short, or bet against them. Credit default swaps are insurance or shorts linked to the value of bonds issued by corporations; governments, from nations to municipalities; mortgage lenders; credit card issuers; auto lenders. Conceivably, CDS can be linked to any bonds or debt. With CDS, one often hears about the "spread," which represents the risk of the debtor defaulting on its obligations to pay back what it owes or what it was lent. That risk is measured or made tangible by being converted into a fee: The spread determines the annual fees, much like an insurance premium, a swap buyer must pay to the seller, which functions much like an insurer. The deal requires the seller to make a lump payout to the buyer if the debtor goes bankrupt, or if the debtor fails to pay on time what it owes. (Or in the case of "pay-as-you-go" mortgage CDS, the seller must make incremental payouts on each loan on which a homeowner defaults or fails to pay.) It also requires the seller to post collateral (make payments) to the buyer if the risk of default of the bonds underlying the CDS rises. The greater the risk grows of default on the bonds linked to the CDS, the more the CDS is worth, to the buyer betting against or "insuring" the debt; and the more costly it becomes for the seller. Vice versa if the debt's default risk decreases: The CDS becomes more valuable for the seller as the debt "being insured" or shorted is deemed safer, which ramps up the cost of "insurance" or "the short" for the buyer. Yet, buyers of CDS can potentially make money several ways: By selling CDS after their value rises to parties needing to cover their exposure to the troubled debtor involved, by receiving collateral from the CDS seller as the risk of default on the underlying debt rises, and/or receiving from the CDS seller a lump or incremental payout (like an insurance settlement) to cover the default of the bonds if they totally tank. The value of those payouts sellers must make to buyers - the insured or shorted amount - is often in quantities much larger than the sum of fees the buyer pays to the seller to hedge (insure) or short (bet against) the debt the swap references. However, most speculators cash out by selling CDS to others needing the protection, because waiting for defaults poses counterparty risk: that the seller could at any time become financially unable to make the lump or incremental payment or post collateral.

For instance, the yearly cost of shorting $10 million worth of swaps on MBIA, a firm hit hard by the financial crisis that guaranteed or insured mortgages and other bonds, was just $100,000 per year in 2004. Using credit default swaps linked to MBIA, activist investor Bill Ackman, the founder of Pershing Square Capital Management, made $1 billion net from a six-year short on MBIA. It took awhile for the value of those CDS, the cost of protecting from MBIA's default, to rise, but the trade started making money for Ackman late in 2007, although MBIA's troubles began months earlier in January. John Paulson, principal and founder of Paulson & Co., a hedge fund, cashed out similar shorts using CDS tied to mortgage bonds and mortgage-linked companies, making a record $3.7 billion for himself in 2007; at the time the largest annual personal take in Wall Street history.

Yet, some might remind us in the case of AIG that, while honoring contracts is a basic legal tenet, so is the practice of renegotiating them when their terms don't fit at all with the reality at hand. The fact that the big banks had paid a fraction into the swaps contracts that paid them using taxpayer dollars at full market value - many more times over what the banks paid to maintain these trades over their lifespan - during a time when the credit risk of everyone involved was fragile and deteriorating, strikes some as unnecessary, others as imprudent, and still others as egregious and absurd.

Case in point: According to McClatchy Newspapers, one package of CDS wagers Goldman entered into with AIG, ended up costing taxpayers between $1.5 billion and $2 billion in payments to Goldman, for which Goldman is thought to have paid (or invested) less than $10 million. If so, that's a 15,000 percent return on investment. Paid for by you and I.

(Yet another quick aside: There are a lot of different swaps. Interest rate swaps differ from credit default swaps, for instance, but both are two of the largest growing and most widely used of the over-the-counter derivatives. Interest rate swaps enable users to swap their floating for fixed rate interest rate exposures [or payment streams], and vice versa. They are used to either speculate on interest rate movements, or mitigate adverse effects from interest rate changes on purchasing, lending, credit lines and other business arrangements. We'll better delineate most of the different types of swaps and derivatives covered in the bill at the end of this post.)

But back to the legislative matters at hand: According to the U.S. bill, only the most generic, "plain vanilla" swaps must be cleared. Stateside regulators have yet to specify the characteristics that will determine exactly which brand of swaps will be considered "standardized" enough to require clearing, and which type will not. However, although empowering both the Securities and Exchange Commission and the central clearinghouses to determine which swaps get cleared, the bill makes it seem more probable that the clearinghouses, many of which are backed or governed or heavily influenced by their big bank members, will be doing most of said determining. Although the bill does call upon the SEC to study each swap to determine whether it should be cleared or not, securities lawyers discount that the agency would embark on requiring clearing of swaps that said clearing firms (or their big bank customers) don't already clear or want cleared. The bill spends more time (several pages) describing the processes for how clearinghouses will essentially determine swaps clearing requirements by deciding which swaps they will clear, decisions that can be influenced by their biggest bank-members versus the several paragraphs that describe the seemingly standalone SEC reviews undertaken for all (including non-cleared) swaps. The section does list general parameters the SEC should use in determining whether certain swaps should be cleared or not, including the size of the market; trading liquidity (the ease with which a security can be traded, which requires a fair number of willing buyers or sellers and is often measured by volume traded); the extent of adequate pricing data on such trades; availability of a rules framework; capacity, operational expertise, resources and credit support infrastructure to clear the contract on terms consistent with available trading conventions.

In this way, though, one might reason, couldn't the banks that control the main derivatives lobby group, the International Swaps and Derivatives Association (ISDA), which sets the conventions the bill mentions, by default control what type of swaps get cleared, essentially, if the ISDA's bank members decide to disregard, or simply don't push to establish, conventions for swaps they'd rather remain "custom" or non-standard, and therefore, less regulated? While motivations are hard to verify, one of the motives potentially involved here would be profit. The big banks' profit margins are often the highest in unregulated markets which lack centralized clearing and other risk controls. That includes the $28 billion earned from derivatives trading last year by the five big banks that control that market. Moody's estimates J.P. Morgan made one-third of its profits in investment banking from derivatives trading from 2006 to 2008.

The bill also asks the SEC to estimate the impact mandatory clearing would have on the mitigation of systemic risk, taking into account the market's size and the resources available to the derivatives clearing organization in clearing a particular contract. The bill explicitly forbids the SEC from forcing clearing of any swap that would "threaten the financial integrity of the derivatives clearing organization," which appears to mean that the riskiest swaps will remain uncleared. One may wonder how that doesn't give overwhelming ammunition to the banks via their influence as the clearinghouses' biggest customers, profit-sharers and in some cases, stakeholders? Can't they essentially claim: "No! That's way too dangerous to the clearinghouses!" every time less generic swaps are suggested for clearing, regardless of how lucrative they may or may not be for the banks when they clear them bilaterally? Another aside: A provision to limit ownership by the banks of clearinghouses and swaps trading systems was stripped from the bill; the final iteration instead calls for the regulators to come up with rules meant to limit potential conflicts of interest that may include (but not require) "numerical limits on the control of, or the voting rights with respect to, any covered swaps dealer."

No test to determine whether "end-users" are trading derivatives to speculate or hedge

So anyway, Congress deems: No central clearing, no collateral (also known as "margin") requirements for “commercial end-users” that use swaps to “hedge.” Ah, but grasshoppper, those words in quotes are precisely where the fuzziness reins: Neither term is defined. At all.

Congress provides no remedy or specific measure to determine what’s "speculation" versus "risk mitigation," nor do they make explicit a definition of “commercial end-user.” Taken together, those exemptions, critics say, could promote risk-taking for a whole bevy of firms that are financially motivated or essentially financial in nature, by allowing them to speculate by buying derivatives, and doing so outside of clearing and collateral requirements that are otherwise aimed at ensuring those players have the financial wherewithal to lose at the game, and do so without ruining it for the other players or everyone else, aside from ruining themselves in the process. Whether this unregulated pocket of the market provides for a safe growth spot for the banks and the end-users, or a spot where trouble festers, or all of the above, remains to be seen.

Regardless, the bill makes it seem that no end-user (nor any counterparty) will be held to any burden of proof at all when it comes to "hedging," meaning there is no explicit test or standard provided that spells out what exactly is considered “speculation” versus mitigating risk via “hedging,” nor is there any method outlined that would have any firm supply a preponderance of reasonably convincing evidence that they are hedging, and truly not speculating; that they are buying derivatives to actually temper risk. All such a firm is told to do is "notify the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps." We use derivatives to mitigate risk; thank you, bye.

So how does anyone prove a firm is speculating instead of allaying risk? Critics say because it’s nearly always debatable, it can be incredibly difficult to discern hedging from speculation. What’s clear is there is no answer in this bill, regardless. And when there’s no clear determinant or definition of speculating and hedging to mitigate risk - whether a trade is speculative or a “true” hedge - one could be said to have “taken one view” on risk regardless of which method or reason for trading one is using. This is important, because presumably, an airline executive, for instance, can take a view using either method; he could both speculate and hedge when trading on the future price of fuel, reasoning that both the risk mitigation and speculation - the latter consistent with his knowledge of the specific market - are concurrent, if not in lockstep, with hedging the operations of the firm’s fleet of planes, when in fact he could be betting on fuel prices in far excess to what he’s hedging or needs to, to "risk manage" his operations.

Note there's no system in place to audit the veracity of boilerplate language in quarterly reports of public firms claiming hedging usage. And not all firms that trade derivatives are public anyway.

Another aside: Just as hard as proving that claims of hedging are in fact speculation: the difficulty in proving that big banks' claiming they're trading to meet customer needs are not simply proprietary trading by another name: The bill bans big "systemically important" banks from "proprietary trading," which means trading for one's own book or account; it's one aspect of the Volcker rule, named for , the former Fed Chairman, Paul Volcker. Problem is: you guessed it, defining "proprietary trading." One can easily structure a deal that's essentially a big bank's solo speculative bet that involves selling one piece of what might involve three separate trades to a firm that supposedly "needs" said piece. Is such a trade proprietary? Or was it made to fulfill customer needs? Shall we request the eye of the beholder? Some in the know reckon that speculating is hedging is proprietary trading is customer-pleasing, interchangeably, or all at the same time, when the big banks can (and they do) see all the trading interests of their big trading counterparties. Also, the rule that the big banks can only invest 3 percent of the "Tier 1" capital in hedge funds or private equity firms? The percentage is said to be set so high (a 40 percent increase over "tangible common equity" for which prior language called), and the banks' required compliance with it to potentially take so long - up to 12 years - as to impact exactly... you guessed it: none of them. Also, while banks that have FDIC insurance or similar government backstopping must spin off into separately capitalized entities any desks trading in non-cleared derivatives, that's only those not considered done for "bona fide hedging and traditional bank activities." As discussed, such limits are constrained by the lack of sufficient methods for determining whether trades are speculative or hedged to mitigate real, tangible risks linked directly to the firm. Plus, banks will be allowed to keep - no questions asked - their swaps desks as long as they're trading interest rate swaps, foreign exchange swaps and forwards, or cleared credit default swaps.

There is one portion of the bill that has us completely baffled: While Congress is also requiring reporting of swaps trades to databases to which regulators will have access, the text used to promulgate said rules is fairly confusing. From what we understand, the counterparties to any swap trades that do not involve a "swap dealer" must choose which among them, which non-bank counterparty, will report their swap trades into a database for monitoring by regulators. However, as far as we can tell from the bill's language, end users would not have to report their trades into regulatory databases for swaps trades that don't involve a "swap dealer" unless they receive a written request to do so from the Securities and Exchange Commission, but that's ONLY if either their swaps were not cleared (for reasons the bill does not specify), or if the end-user counterparties could not meet deadlines to submit their swap trades into reporting systems in whatever the mandated timeframes will be (they're yet to be decided upon by the SEC or the Commodity Futures Trading Commission: The CFTC and the SEC are splitting oversight of the swaps market; the SEC will regulate securities-based swaps like those linked to bonds; the CFTC will regulate swaps linked to commodities like oil).

At the very least, it seems Congress is presuming in the bill that such non-reporting situations will happen, and that it's all good (meaning you don't have to report swap trades) unless you receive a letter from the SEC, if you're an end-user, or an affiliate of an end-user that is facilitating swap trades but not as part of "regular business," as long as the swap database doesn't accept your swap, or regulatory timelines cannot be met. Hmmm. Okay.

Here's the language: ‘REQUIRED REPORTING OF SWAPS NOT ACCEPTED BY ANY DERIVATIVES CLEARING ORGANIZATION.—IN GENERAL.—Each swap that is not accepted for clearing by any derivatives clearing organization shall be reported to—‘(A) a swap data repository described in section 21; or (B) in the case in which there is no swap data repository that would accept the swap, to the Commission pursuant to this section within such time period as the Commission may by rule or regulation prescribe.

then later...

"...if the individual or entity did not— ‘(1) clear the security-based swap in accordance with section 3C(a)(1); or(2) have the data regarding the security-based swap accepted by a security-based swap data repository in accordance with rules (including timeframes) adopted by the Commission under this title....—An individual or entity described... shall— (1) upon written request from the Commission, provide reports regarding the security-based swaps held by the individual or entity to the Commission in such form and in such manner as the Commission may request; and to maintain books and records pertaining to the security-based swaps held by the individual or entity in such form, in such manner, and for such period as the Commission may require, which shall be open to inspection by" any regulator, basically.

The SEC presumably could search companies quarterly reports to determine whether they engage in swaps or other derivatives trading covered by the regulation. But to know if they're ducking the rule to report trades, they'd need to collect the names of counterparties with which the banks are trading, assuming there's some overlap in trading among end-users that trade both with swaps dealers and with firms not considered to be predominantly financial or small enough to be exempt. Yet what data elements the SEC will require the banks to provide to the repositories and the SEC, the SEC has yet to determine. And given all this, note this important caveat: How much swaps trading that occurs between end-users and firms not considered predominantly financial or small enough to be exempt is unknown; there is no completely reliable data available to determine the amount and frequency of such trading. However, such trading does occur, according to the Tabb Group, which cites data from the Depository Trust and Clearing Corporation, the main settlement utility for Wall Street that collects data on credit derivatives trades. Tabb says 0.1 percent of CDS trades reported to are "customer-to-customer." Also, the bill is silent on how "novations" would be treated, and whether they'd be reportable. Novations occur when one party to a trade wants to get out of the trade; "novating" is the act of assigning the trade or giving it up to another party willing to take on whatever hedge, risk or bet is involved. Novations typically involve banks but could very well involve two non-bank institutions.

Anyway, the bill also seems to create a situation that could, emphasis on "could," embolden certain financial arms of companies not generally in the financial business to load up on swaps. The bill says an affiliate of an end-user can use the clearing exemption whenever said affiliate is NOT considered a swap dealer; a security-based swap dealer; a major swap participant; a major security-based swap participant; or a commodity pool. The affiliate also can use the exemption if they are none of the aforementioned and if they are a private fund, such as a hedge fund, private equity firm or similar, with $150 million or less in managed assets (this takes into account new rules in the bill requiring registration of private funds with more than $150 million in assets); or if they're a bank holding company with less than $50 billion in consolidated assets. That, as long, again, as said entity is "predominantly engaged in providing financing for the purchase of an affiliate’s merchandise or manufactured goods," or is "acting on behalf of the commercial end user and as an agent," and "uses the swap to hedge or mitigate the commercial risk of the commercial end user parent or other affiliate of the commercial end user that is not a financial entity."

"The term 'swap dealer,' does not include a person that buys or sells swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business," says the bill. "Swap dealer" does also not include firms that engage in "a de minimis quantity" of swap dealing done with, or on behalf, of their customers. The bill leaves the SEC to determine what exactly that de minimis (or minimal) amount will be.

Also, "financial entity" as defined in the bill, is a company or a person "predominantly engaged in activities that are in the business of banking or financial in nature." What "predominantly engaged" equates with, the legislation says, is a firm that derives at least 85 percent of its consolidated assets or gross annual revenues directly from financial activity. According to the Wall Street Journal, that means non-financial companies with industrial-size finance arms would be exempted from regulation, like GE, because GE's finance arm, GE Capital, accounts for about 83 percent of GE's $777 billion of consolidated assets. GE Capital is not a bank holding company.

But Ally Financial - which used to be called GMAC when it was General Motor's wholly owned finance arm until private equity fund Cerberus took a 51 percent stake in 2006 to separate it from ailing GM - is a bank holding company, albeit majority owned now by the federal government. GMAC, which got caught up in the auto industry's protracted woes, received a $5 billion government bailout late in 2008, and another $7.5 billion in mid-2009. However, GM retains a 6.7 percent stake in GMAC (now Ally) while Cerberus has 14.9 percent. While it has about $160 billion in consolidated assets, Ally's been trying to pare its international assets down. If it were to cut total assets down to $50 billion, it would meet the exemption to centrally clear swaps. One would basically have a bank exempt from derivatives regulation as an affiliate of a manufacturer acting to finance and, officially, hedge said "non-financial" company's core business purchases - something it's proven to have had a bit of trouble with prior (although past performance is no guarantee of future results).

One firm whose affiliate does for sure come under the $50 billion threshold, although it's not a bank holding company: Google, which in January opened its own trading floor to manage $26.5 billion; the investment operation is structured to deploy said financing for Google's own mergers and acquisitions.

And oil giant BP: arguably exempt. According to the New York Times, its trading operations have made between $2 billion and $3 billion since 2005. And while we may be out on a limb, we venture that the revenues it took to tally those profits have been well below the $209 billion of revenues that represent 85 percent of BP's overall sales for 2009. It'll be up to regulators to decide that the trading arms of firms like BP, Shell or Cargill, when they're transacting with or offering derivatives to other "end-customers," whether that constitutes "market-making," which would deem them "swap dealers" and thus not exempt from collateral and clearing requirements. A market-maker is someone who quotes both a "buy" and a "sell" price in offering financial instruments, requiring said someone or company to hold enough securities to be able to do either. Said firm can sell from its own inventory or obtain an order from some other person or firm to fulfill its market-making duties. The aforementioned companies could argue they are not enough in the derivatives business or they do not hold enough inventory to be able to "make markets."

So, given all that (phew!): Is there a danger for such industrial or corporate financing arms to get in trouble speculating with derivatives, or to start what's essentially a small hedge fund or bank or private equity affiliate to do so? Time will tell.

It's also hard to know if any of this means banks will focus on selling more swaps to corporates, because thus far, no one we've reached out to on the issue will talk. Whether that portends reticence and for what, we've no idea. Anyway, of the 11 people we contacted yesterday on this matter, including heads of derivatives marketing at several major banks, derivatives software vendors, "commercial end-users," a solo (or "prop" for proprietary) trader that uses automated software to manage his own money, and an executive at a boutique broker, only one of them - the prop trader - responded to our questions.

The prop trader could not confirm our logical surmising about an uptick in derivatives sales to corporates. "Sorry," he said, "I don't have any particular insights in banks' next push in derivatives sales." He used to build IT risk and analytics systems for the derivatives operations of two of the world's largest banks.

But for what it's worth, he did predict that the next financial "crash" will involve non-financial companies "through derivatives" in a blog post that had inspired us in the first place to email him. In response to our questions, he emailed referring first to his post:

"That was a general statement in the sense that, as long as systemic correlation is intact through the combination of high leverage, highly complex web of counterparty exposure, nonsensical accounting rules, and oversized financial sector, the next crisis is only a matter of when/how/where, not if.

"[But] you bring up a very valid concern. Many traditional "manufacturers" such as GE, BA [Boeing], GM have already been deeply involved in derivatives. The temptation is irresistible once you learn that you can boost earnings without actual hard work, just by playing the derivatives trick and shift earnings/liabilities back and forth across time, here and there across countries/regions/units. So I wouldn't be surprised if what you're pondering becomes true. No, wait, it already happened in Enron. In fact, there have been many examples of disastrous "end user" misuse of derivatives everywhere -- Europe, China, etc. The notion of "end user exemption" is ludicrous."

Strongly opinionated. But sooth? No idea. We'll update if we find out more.

Endnote Data:

"Notional" basically means total; it refers to the total amount of derivatives contracts written. But because some of those contracts cancel (perfectly or partially hedge) each other out, the "net" number of money risked in the system is lower than the total amount of outstanding contracts. The sheer volume, however, can make "netting" down trades, and tracking them down to do so, quite an endeavor.

Here's the ranking of types of derivatives by outstanding notional (total) volume among the $614.7 trillion in over-the-counter derivatives the Bank of International Settlements (BIS) counted in a survey at the end of last year, which includes options and forwards: 1.) interest rate swaps, at $449.8 trillion; 2.) foreign exchange contracts, at $49.2 trillion; 3.) credit default swaps, at $32.7 trillion; 4.) equity-linked contracts, at $6.6 trillion; 5.) commodity contracts, at $2.9 trillion. A mysterious category BIS calls "unallocated," at $73.5 trillion, would otherwise rank second, but we leave it out as, according to BIS, it refers to "non-regular reporters'" holdings of foreign exchange, interest rate, equity, commodity and credit derivatives contracts - those held by commercial and investment banks and securities houses that do not participate in the BIS' semi-annual survey, but contribute to its triennial survey; what BIS considers "regular reporters" are those firms with headquarters in any of the 11 industrialized countries known collectively as the Group of 10 - Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

Companies or corporate treasuries' involvement in credit default swaps trading appears to be rising. According to the Bank of International Settlements, last year showed record credit default swaps holdings for non-financial “corporates,” which made up 4.8 percent ($1.6 trillion) of the $32.7 trillion in total notional amount of CDS outstanding as of Dec. 2009. CDS notional holdings among non-financial companies had steadily rose each year until the second half of 2008 during the worst of the financial crisis when CDS volumes overall decreased for the first time. While overall notional CDS holdings continued to decrease through each half of 2009, non-financials holdings increased in each of those halves last year.

As of December 2008, company holdings of CDS totaled 1.2 percent ($494.8 billion) of the $41.9 trillion in total notional amount of CDS outstanding then. They represented 1.2 percent ($726.5 billion) during the CDS market's all-time overall peak of $58. 2 trillion outstanding at 2007's yearend; they tallied 3.8 percent ($109.1 billion) of $28.7 trillion notional amount of CDS outstanding at 2006's yearend, which represented record volume for non-financials until last year.

As for interest rate swaps, corporates' holdings had steadily risen since records have been kept until those outstanding dipped in the second half of 2007. They have fluttered up and down since: Holdings by non-financial firms rose again in the first half of 2008 before falling again in the second half. Then they rose in the first half of 2009 before dipping again by yearend last year: Corporates held 13 percent or $30.6 trillion of the $230 trillion in total notional outstanding at 2006 yearend; 11 percent or $33 trillion out of $310 trillion total notional outstanding at 2007 yearend, which came after record holdings of $39 trillion for non-financial companies in the first half. Companies tallied 10 percent, or $32 trillion out of the $310 trillion in total notional outstanding of interest rate swaps at the end of 2008; and 8.7 percent or 30.3 trillion out of $349 trillion of these swaps outstanding last year. Overall holdings of interest rate swaps outstanding had steadily increased since records have been kept to a peak of $357 trillion in the first half of 2008, until dipping for the first time ever that year in the second half. Total holdings have risen since, increasing over each half last year.