Would you like to put that in a default swap?

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Why Swaps Matter

Mark Whitehouse writes editorials on global economics and finance for Bloomberg View. He covered economics for the Wall Street Journal and served as deputy bureau chief in London. He was previously the founding managing editor of Vedomosti, a Russian-language business daily.
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The congressional wrangling to avoid a government shutdown -- with its attendant noise about a thing called the swaps push-out rule -- has brought useful attention to some unfinished business of financial reform: loosening the largest U.S. banks' grip on the derivatives market.

Six years after the 2008 financial crisis, these institutions still dominate a market that had a starring role in that disastrous episode. As of June, the three top banks -- JPMorgan Chase, Citigroup and Goldman Sachs -- had written derivatives contracts on the equivalent of about $182 trillion in assets, up from $158 trillion in 2008, according to the Comptroller of the Currency. Here's a chart:

And here are the 10 bank holding companies with the largest derivatives positions as of June:

Why might this be a problem? Derivatives allow banks and investors to make bets on the performance of assets such as stocks, bonds and currencies without putting much money down. Such leveraged positions can quickly generate big gains or losses, and can trigger sudden, large demands for added cash collateral -- events that are not particularly desirable for institutions crucial to the functioning of the economy. To be sure, the banks typically provide a sort of bookmaking service, taking bets that more or less cancel each other out. But not always: JPMorgan lost more than $6 billion on credit derivatives bets in 2012, and several big banks -- including Goldman Sachs and Citigroup -- required a government bailout after insurance giant AIG couldn't meet collateral demands on its souring mortgage bets in 2008.

The banks have remained so dominant in large part thanks to a special advantage: They are able to finance their derivatives positions cheaply, because their creditors assume the government will rescue them in an emergency. Their central role in derivatives trading, in turn, serves to reinforce their too-big-to-fail status. The largest bank holding companies have gone so far as to put almost all of their derivatives in their deposit-taking subsidiaries, which enjoy the added benefits of federal deposit insurance and access to emergency loans from the Federal Reserve.

Put another way, the banks can take federally insured deposits and use the cash to post collateral on derivatives bets. That's according to the Federal Deposit Insurance Corp.

The Dodd-Frank Act of 2010 gave regulators a number of tools to rein in the derivatives operations. They can reduce the value of government support by requiring banks to have ample capital to absorb potential losses, and cash on hand to meet collateral calls. They are setting up central counterparties and trading hubs aimed in part at encouraging investors to do business directly with one another, rather than going through the big banks. In both areas, they have a long way to go.

Which brings us to the swaps push-out rule, a piece of Dodd-Frank that would require the banks to move a small but risky portion of their derivatives out of their deposit-taking subsidiaries and thus remove them from explicit federal support. If you've read this far, you'll understand why this is sensible policy. Bank lobbyists have long been trying to kill the rule, and a provision doing just that is included in the spending bill that passed the House yesterday and is expected to pass the Senate this weekend. 

Banks' assertion that the swaps push-out would be unduly complicated isn't convincing. When their survival was at stake back in late 2008, both Goldman Sachs and Morgan Stanley managed to transform themselves into traditional bank holding companies in short order. As of March 2009, Goldman's derivatives business was almost entirely within its relatively small depository subsidiary, according to the Comptroller of the Currency. Morgan Stanley still keeps most of its derivatives outside the deposit-taking unit.

The swaps rule wouldn't eliminate the banks' advantages or make their derivatives operations safe on its own. But it would be a useful part of a broader financial reform.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net