AFR Derivatives Response to the New Democrat Coalition Letter

June 16, 2010

To Members of the H.R. 4173 Restoring American Financial Stability Act of 2010 Conference Committee

Washington, DC 20510

Dear Conferee:

We write on behalf of Americans for Financial Reform, an unprecedented coalition of over 250 national, state and local groups who have come together to reform the financial industry. Members of our coalition include consumer, civil rights, investor, retiree, community, labor, religious and business groups as well as Nobel Prize-winning economists. We support strong derivatives regulation and we strongly support the derivatives language passed by the Senate.

We understand that some members of the New Democrat coalition have drafted a letter including analysis of the Senate derivatives title. We agree with their argument that “the inability of regulators and the private sector to evaluate existing risks exacerbated the financial crisis” and we therefore think it is essential that regulators are able to oversee the vast majority of derivatives trades going forward.

We disagree strongly, however, with the letters’ analysis of the legislation. Strong derivatives regulation is key to preventing future financial crises, and we are convinced that the Senate language is needed to accomplish this goal.

Clearing and Reporting

Letter: “The House bill contained strong provisions requiring all derivatives – without exception – to be cleared through clearinghouses, traded on public exchanges, and/or reported.”

AFR response: ‘Or’ is the key word in the sentence above.  Reporting alone is not enough. Clearing and exchange trading are both essential because clearing – and the margin requirements it entails – provides for safety and soundness in the derivatives markets,  and exchange trading ensures that there is transparency in these markets.

Experts have estimated that the House language would require around 60% of swaps to clear whereas the Senate language would require about 90% of swaps to clear and exchange trade. The House allows a large portion of the derivatives market to escape the clearing requirement because it allows an exception from clearing for hedging “operating or balance sheet risk.” This is a dangerous loophole that could allow hedge funds, insurance companies, banks and other financial players to escape the clearing requirements. If adopted, the House language would exempt companies like Long Term Capital, AIG, Indy Mac and Countrywide.

End User Exemption

Letter: “The House also provided clear protections for end users who pose no risk to the stability of the financial system so they may continue to use derivatives to prudently manage their risks.”

AFR response: The Senate legislation also exempts end users. It does so in a clearly defined way that allows commercial end-users hedging commercial risk to choose whether or not to clear their swaps,  while ensuring that risky financial institutions are required to clear and exchange trade all standardized swaps. The Senate language strikes the right balance while the House language includes a dangerous loophole that could allow hedge funds, insurance companies, banks and other financial players to escape the clearing requirements, undermining the essential goal of reform.

Captive Finance Subsidiaries

Letter: “[T]he Senate-passed definition of ‘financial entity’ would significantly limit the ability of many legitimate commercial end users to finance their operations, because of their existing captive finance facilities or their controlling ownership structures.”

AFR response: Section 723 of the Senate bill addresses this concern by explicitly permitting  “[a]n affiliate of a commercial end user (including affiliate entities predominantly engaged in providing financing for the purchase of the merchandise or manufactured goods of the commercial end user)” to also be exempt as a commercial end user.

Protecting States, Cities and Pension Funds

Letter: The fiduciary duty established in the Senate bill “will impair the ability of these entities to manage risk and issue bonds, and therefore should be eliminated.”

AFR response: Revised language worked out by members of the Agriculture and HELP Committees preserves the ability of pension funds, government entities, endowments and retirement plans to engage in swaps transactions while helping to ensure that swaps dealers cannot exploit their lack of sophistication in order to lure them into transactions that are harmful to their interests.


It clarifies that the heightened standard of conduct constitutes a duty, comparable to that under the Investment Advisers Act, to have a reasonable basis for believing that the transaction is in the best interest of the customer.  And it applies that duty only where there is some advice offered or recommendation made by the swaps dealer.  It does not apply, for example, to transactions initiated by the special entity in which no advice is offered.  Such transactions would be subject only to basic business conduct rules.

Separate Risky Derivatives Trades from Taxpayer-Protected Banks

Letter: Section 716 of the Senate bill, which requires the separation of swaps dealing from taxpayer-protected banks, “would increase systemic risk by forcing derivatives transactions into less regulated and less capitalized institutions and impede effective regulatory oversight of the derivatives markets.”

AFR response: Section 716 increases stability in the system and protects taxpayers. Swaps desks that are moved to bank affiliates will be required to maintain adequate capital and be subject to strict regulatory supervision.  The high-risk activity of derivatives dealing will be firewalled from federally-insured deposits and the taxpayer subsidy of near-zero-interest loans from the Fed window.  No other measure in the House or Senate bills protects the taxpayers in this manner.


Americans for Financial Reform

CC: Members of the Financial Reform Conference Committee