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Democrats are trying to find a compromise on the regulation of the derivatives market. Chris Dodd and Blanche Lincoln have competing versions in the Senate. Sen. Lincoln’s would require banks to spin off their trading desks to be eligible for assistance from the Federal Reserve or FDIC. Dodd’s proposal is not as draconian. Via the WSJ:
The tentative agreement reached by two key Democrats Sunday on a plan to crack down on trading in derivatives would potentially force banks to spin off their operations that trade the exotic financial instruments.
The plan, worked out by Senate Banking Chairman Chris Dodd (D., Conn.) and Senate Agriculture Chairwoman Blanche Lincoln (D., Ark.) closely follows legislation"”originally written by Ms. Lincoln"”designed to boost federal oversight and transparency of the derivatives market.
Some administration officials have argued the proposal drafted by Ms. Lincoln could hand control over the derivatives market into just a few companies, such as hedge funds, over which regulators have less control. Before the deal was reached, Austan Goolsbee, a member of the White House Council of Economic Advisers, declined to support that idea, noting “technical” disagreements to be sorted out.
Mr. Dodd had previously been working on a less onerous alternative that would not have forced the spinoffs.
Many companies, from industrial to agricultural concerns, use derivatives to hedge against economic risks, such as changes in interest rates. But derivatives trading has also become one of the most profitable activities by Wall Street’s largest banks, which dominate the business. The business generated revenue of about $20 billion in 2009, according to Comptroller of the Currency and industry estimates.
Supporters say Ms. Lincoln’s proposal is the best way to prevent Wall Street banks from leveraging deposit insurance and other government support to fuel risky speculation, which played a part in the market collapse in 2008.
Under the deal, the derivatives portion of the bill would include a provision that would force banks to spin off their derivatives trading desks to be eligible for federal financial assistance from the Federal Reserve and Federal Deposit Insurance Corp. That would ensnare most big Wall Street players.
The Senate proposal is more aggressive than the regulatory overhaul approved by the House last year, which did not encourage banks to spin off trading operations. The issue is likely to be fought again on the Senate floor, where some Republicans and perhaps some Democrats including Sen. Kristen Gillibrand of New York are expected to attempt to kill the provision, once debate opens on the broader legislation.
I have a better proposal. Tell the Fed to stabilize the value of the dollar and the volume of derivative trades will shrink to the point where they cannot harm the financial system. Derivatives are necessary because of currency volatility which leads to commodity and interest rate volatility. An adverse move in the price of a key commodity or interest rates can wipe out profits for a company improperly hedged against the risk (see here and here for example). So the underlying problem is not that the banks are trading derivatives. The banks are merely meeting the demands of the marketplace. If their clients want or need to hedge, banks will provide that service and earn a fee. The underlying problem is that commodities and other key cost variables are too volatile. If we solve the volatility problem, the derivative problem will solve itself. The key to reducing volatility is to stabilize the value of the dollar.
Past periods of fixed exchange rates are associated with low commodity price volatility and periods of free floating exchange rates are associated with high commodity price volatility:
During the period of the pure gold standard from 1880-1913 (when the Federal Reserve was established) the standard deviation of commodity prices was roughly 4.5. During the free float period from 1914-1926 the standard deviation at least doubled (there are differences depending on which commodity index is used). During the Bretton Woods era from 1945 to 1971 commodity price volatility was reduced again to a standard deviation of about 8. Since 1971 volatility has again risen to about 15. (Cuddington and Liang 2003)
Warren Buffet has called derivatives financial weapons of mass destruction but the derivatives themselves are not the problem. The true weapons of mass destruction are floating exchange rates. Derivatives are financial fallout.
[...] Reduce the Need for Derivatives | Contrarian Musings alhambrainvestments.com/blog/2010/04/26/reduce-the-need-for-derivatives – view page – cached Democrats are trying to find a compromise on the regulation of the derivatives market. Chris Dodd and Blanche Lincoln have competing versions in the Senate. Tweets about this link Topsy.Data.Twitter.User['alhambralnvest'] = {”location”:”Miami, Florida”,”photo”:”http://a3.twimg.com/profile_images/255954559/Logo_normal.png”,”name”:”Contrarian Musings”,”url”:”http://twitter.com/alhambralnvest”,”nick”:”alhambralnvest”,”description”:”Keep up to date with our observations of the latest news and trends affecting the financial markets at our blog, Contrarian Musings.”,”influence”:”"}; alhambralnvest: “Reduce the Need for Derivatives http://bit.ly/dA95Wp ” 24 minutes ago view tweet retweet Filter tweets [...]
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