The crazy congressmen from Capitol Hill are at it again!
By a bizarre anomaly of the US regulatory system, the body responsible for overseeing Credit Derivatives in the US is the Congress House Committee on Agriculture, I kid you not!
In various posts I have speculated that maybe a lifetime spent regulating pork belly or orange juice futures may not have fully equipped this particular committee to regulate global financial markets in complex derivatives (see Hillbillies and Animal Farm).
In February, the House Committee went a little further in proving that I might have a point, when passing the wonderfully named "HR 977: Derivatives Markets Transparency and Accountability Act of 2009".
Traditionally, the Committee operates through the Commodity Futures Exchange Commission (CFTC). The CFTC regulates commodities traded on US exchanges, such as the Chicago Board of Trade where futures and options commodities such as "mini-sized soybeans" and "rough rice" are traded. The CBOT also permits trading in certain financial contracts, such as 30-year bonds and the Dow Jones Index futures.
Note, these are all so-called Exchange Traded Contracts (ETC), which are traded on recognized exchanges and settled on recognized clearinghouses according to pretty restrictive rules, enforced rigorously by the CFTC. The markets regulated by the CFTC are large and sophisticated and as far as we know, sound, since no part of the Global Financial Crisis (GFC) can be attributed to anorexia pigs or wimpy wheat.
However when looking at Credit Derivatives, the Committee are, like Dorothy in the Wizard of OZ, "not in Kansas anymore".
Credit Derivative Swaps (CDS) are not traded on regulated exchanges but are commercial 'contracts' agreed between two parties, so-called Over The Counter or OTC transactions.
Like a frisky bull in springtime, the Committee, however, seems quite prepared to leap over this particular fence and start to regulate/dabble in areas of commercial law.
In Section 16 of the new Act, the committee has given the CFTC truly draconian powers to "summarily suspend trading in any credit default swap" and to "summarily suspend all trading on any contract market, derivatives transaction execution facility, or otherwise, in credit default swaps". Note that the un-elected CFTC may take such dramatic steps if in its own opinion "the public interest and the protection of investors so require".
Before considering some of the unintended consequences of the Committee's (bull in a china shop) foray into international finance, it is worth asking - what does the august body actually mean by a Credit Default Swap?
Never fearful of falling on their collective faces into a cow-pat, the committee actually go so far as to enshrine a definition of a CDS into US law: "the term 'credit default swap' means a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade".
Note the definition does not actually define a CDS but gives an example (such as default or downgrade). And a quick look at the definition would also show that it is extremely broad and probably covers lots of other OTC derivatives, such as Interest Rate Swaps, where any 'event' can occasion a loss!
Lawyers must already be licking their lips at the fees that will be earned debating this 'definition'?
Having defined CDS, the question then is whether the CFTC actually has the power to suspend any and all trading in contracts that just might include the words 'Credit', 'Default' or 'Swaps'.
What if, say, JP Morgan has signed a commercial contract with UBS Switzerland that walks and squawks like a CDS? According to HR 977, the CFTC may 'summarily suspend' this transaction if they think fit. Does that mean that they suspend the JP Morgan side or the UBS side, or, for example, the UK side, if the contract was signed by separately regulated UK subsidiaries of each bank? Does this mean that the CFTC has jurisdiction over UK commercial law? If so, has anyone told the House of Commons this yet?
What if, for example, JP Morgan was not involved, but the contract was between UBS and Credit Suisse under Swiss commercial law, and was based on an event for a US company, such as IBM? Can the CFTC intervene; say when IBM comes under short-selling pressure, which surely counts as public interest?
And even if the parties were in fact all US based, has the CFTC the power to interfere with perfectly legal contracts, entered into voluntary by knowledgeable parties?
Lawyers must already be window-shopping at Rolls Royce dealers in anticipation of the fees that will be earned fighting the resulting cases all the way up to the US Supreme Court.
As noted elsewhere, the House Committee on Agriculture appears not to understand that the market in OTC contracts (not just derivatives) is global, covered by laws in many different jurisdictions and overseen by bodies unfamiliar with the peculiarities of the US regulatory system.
HR977, if enacted, will be strenuously opposed by financial institutions because it creates exactly the type of 'regulatory arbitrage' that drives firms to move away from regulated markets to open up offices in more compliant jurisdictions. Which European or Asian bank is going to sign a contract with an American institution if the agreement can be summarily annulled by a third party whose expertise is in Soybeans? I think very few!
But this does not deter the Committee on Agriculture, who are much more than the biblical 'sons of the soil' or 'hewers of wood and drawers of water'. They are like the Wizard of Oz who boasted that "you are talking to a man who has laughed in the face of death, sneered at doom and chuckled at catastrophe."
They are not to be deflected by mere points of law or questions of feasibility, but will plough on regardless, humming the immortal words of L. Frank Baum, for the Scarecrow in the Wizard of Oz:
"I could while away the hours/conferrin' with the flowers/consultin' with the rain/And my head I'd be scratchin'/ While my thoughts were busy hatchin'/If I only had a brain."
