A $4 Trillion Dodd-Frank Loophole

Photograph by Scott Eells/Bloomberg

To improve the safety of the financial system, the Dodd-Frank reform law requires that most derivative deals be executed on a clearinghouse that will require traders to post collateral and will provide a central place for regulators to keep an eye on risk in the market.

The idea was to increase transparency in a market that played a key role in the financial crisis and led to the federal $182.3 billion bailout of American International Group in 2008.

But for every new rule, there is a frantic search for new loopholes. And sure enough, banks have found a big one.

Our colleague Bradley Keoun at Bloomberg News has a fascinating story about how some of the country’s largest banks are planning to help clients circumvent new requirements in the law. The move lets traders “transform” risky securities into the high-grade bonds that clearinghouses require traders to post as collateral. Traders and investors do this by temporarily swapping out their lower-grade securities for high-grade bonds such as Treasuries, which are in great demand these days as investors and banks shore up their books.

The traders are happy because they have the quality collateral they need, and the banks are happy because they collect fees and interest for lending out their goods. Bank of New York Mellon estimates that investors will need as much as $4 trillion in good collateral to comply with the new regulations.

If things go well, this scheme would operate smoothly. But if traders go bust, banks could be left holding risky bonds instead of high-grade securities. Also, if the banks themselves originally had borrowed the high-grade bonds, the original lender might set off a domino effect through the market by calling back the collateral.

Banks say swapping out collateral doesn’t hide risk because the banks are regulated, too. Barclays says banks have their own new capital requirements, which might limit how much they can lend, and JPMorgan Chase spokeswoman Jennifer Zuccarelli told Bloomberg News that collateral transformation isn’t risky because it’s a short-term, established type of lending that is “subject to tight capital and liquidity rules and fully transparent to regulators.”

In July, regulators reached a major milestone when they approved rules specifying which types of derivatives must be traded over clearinghouses, as well as face further requirements. Bart Chilton, a Democratic commissioner at the U.S. Commodities Futures Trading Commission, opposed the rules, saying they provided too many exemptions. The rules excluded insurance and retail transactions and trades by many non-financial companies and small banks. Chilton said he was concerned that the financial industry would take advantage of the loopholes and that exempted trades designed for “legitimate purposes are going to morph, kind of chimerical,” into more complex, riskier financial products.

The CFTC and other regulations still have more rules to finalize, each striving to make markets less risky—and each providing new items for the industry to scour for loopholes.

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