Banks are finding it harder to fight proposed reforms of the $300 trillion U.S. privately traded derivatives market because of outrage over JPMorgan's credit derivatives losses.
Lobbying efforts continue, nonetheless, as many important rules have not been hammered out.
The industry pushback against proposed regulations mandated under the Dodd-Frank legislation of 2010 was the latest move in the roller-coaster world of financial crisis and reform.
The Dodd-Frank reforms were launched in response to the financial crisis in the wake of the collapse of Lehman Brothers, only to spawn a new round of bills in Congress to override the ability of regulators to implement and enforce changes.
The pushback had been gaining momentum before JPMorgan Chase & Co. said in May it lost at least $2 billion failed derivative trades.
But the furor over JPMorgan's losses has made passage of these bills less likely, said sources who are in regular contact with members of Congress.
On Friday, JPMorgan said its losses came to at least $5.8 billion, some of which may have been hidden purposely.
"We definitely saw people stepping back from public support of this kind of legislation after JPMorgan's derivatives losses," said Marcus Stanley, a policy director at Americans for Financial Reform, a coalition of more than 250 consumer, community, labor, small business and other pro-reform groups.
The proposed legislation seeks to broaden exclusions from central clearing, reduce margin requirements and effectively kill regulatory proposals to enforce trade price transparency.
These reform measures are seen as key to reduce the risks of the markets, where trade opacity and interconnection of the contracts among large banks were blamed as key factors behind the financial crisis.
A small group of the world's largest banks profit greatly by dominating these markets. Income from privately traded derivatives generates about $55 billion a year, or 37 percent, of bank revenues, according to a report by advisory and consulting firm Deloitte last year.
Four years after the crisis, anger over the failures of banks including Lehman Brothers and the subsequent bailout of the financial sector had been subsiding. Intense lobbying efforts by banks seemed to be swinging lawmakers in favor of more lenient regulations.
But JPMorgan's losses were a stark reminder of the risk that banks and other large companies can use derivatives to build large, risky portfolios with few disclosures to investors. It has wounded the credibility of JPMorgan's chief executive, Jamie Dimon, who has been a staunch critic of much of the Dodd-Frank reform.
"When you get an event like that it informs public policy debate," said Gary Gensler, chairman of the Commodity Futures Trading Commission, the main U.S. derivatives regulator. "It may have changed the public discussion," he said on the sidelines of a conference in New York last month.
DECONSTRUCTING DODD FRANK
Lawmakers have sidelined bills that would have watered down some of the regulations that banks have been fighting most, while progress on other bills has slowed.
The bills sought to rewrite Dodd-Frank and override rules designed to open up the market to new players by reducing the role of large banks as intermediaries, hurting their profits.
The opacity of derivatives allows the dominant banks to charge higher fees on trades through wider bid/offer spreads. They also benefit from an effective oligopoly for trades that are not subject to central clearing.
In such trades investors are exposed to the credit risk of the bank they trade with, limiting them to working with banks that are "too big to fail." Banks want to keep that structure.
"They are trying to keep it in the existing framework, there has been a lot of lobbying efforts to keep that as close as possible," said Peter Tchir, founder of financial advisory firm TF Market Advisors.
Reforms including central clearing, electronic trading and more price transparency would significantly reduce earnings from derivatives and compress margins by as much as 35 percent over the next two to three years, Deloitte said.
On May 15, the House of Representatives Agriculture Committee postponed a planned hearing on three bills, including one that opponents say would allow banks to skirt regulations by trading through foreign affiliates, such as those based in London.
The committee chairman, Frank Lucas, a Republican from Oklahoma, sought more time "to ensure there are no unintended consequences of the legislation that would encourage recklessness in our financial institutions."
"I do think this has touched a nerve in the American public," said Michael Greenberger, a law professor at the University of Maryland and former director of trading and markets at the CFTC. "This shows it's not over and there could be other choppy waters out there."
Among bills pending, one in the House of Representatives seeks to override a proposed CFTC rule that would require prices be flashed to several dealers before trades are made, when the contracts are subject to central clearing.
Others propose to further expand the number of companies that are excluded from central clearing requirements.
Another bill — this one before the Senate — seeks to exempt "small banks" from central clearing, though in practice it could exclude banks with notional derivatives portfolios as large as $200 billion, said AFR's Stanley.
Although these bills are now less likely to pass, the industry has won some smaller battles.
On Tuesday the CFTC added an exemption for banks with up to $10 billion in assets from rules that would require central clearing. This will capture 98 percent of U.S. banks, and represent around 15 percent of bank assets, Stanley said.
Some banks had argued the exemption should apply to banks with as much as $50 billion in assets.
The CFTC further voted to exempt a number of large non-financial firms from clearing requirements. It also excluded some commodity forward contracts from regulations, leading Commissioner Bart Chilton, a Democrat, to oppose the rule, the first final CFTC derivatives rule he has voted against.
"Potentially it could be the new Enron loophole," he said. "There are attorneys out there hawking ways around Dodd-Frank."
CFTC meeting records show ongoing lobbying on topics including the CFTC's reach over foreign bank branches and exemptions from clearing requirements, and many key rules, including those related to bank ownership of clearinghouses and other entities have not yet been made final.
The legislative maneuvering shows how much derivatives reform may change in the event of a victory by Mitt Romney, the presumptive Republican nominee, in the November presidential election. A win by Romney, who has said that he would repeal Dodd-Frank, would turn control of the CFTC over to Republicans.
Republican CFTC commissioners Scott O'Malia and Jill Sommers have opposed several CFTC rules, saying they exceed Dodd-Frank's intentions.
O'Malia has also issued three dissents over budgetary increases for the CFTC while its chairman, Gensler, has argued that large increases are necessary due to the added responsibilities of overseeing the derivatives markets.
U.S. Senate appropriators approved funding boosts for the CFTC and Securities Exchange Commission last month, setting up a likely battle with Republicans.
Still, rules passed at last week's CFTC meeting starts a clock that will cause many rules to take effect before the election, including public reporting of price and volume information for credit and interest rate derivatives index trades.
"Light will begin to shine on the markets for the first time," Gensler said.
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