Derivatives Still Remain a Ticking Time Bomb for the Biggest Wall Street Banks

The most dangerous derivatives – credit derivatives that mainly consist of credit default swaps – are only 36 percent centrally-cleared a decade after the passage of Dodd-Frank.

By Pam Martens and Russ Martens of Wall Street on Parade.

Last week, the New York Times’ Emily Flitter, Jeanna Smialek and Stacy Cowley provided an excellent rundown of the dangerous rollbacks of regulations on the big banks by federal regulators appointed by Donald Trump.

Today, in preparation for a hearing with these regulators, the House Financial Services Committee has released a Memorandum that further outlines how the safety and soundness of the biggest banks have been impacted by changes to regulations.

Many of the rollbacks or watering down of the bank rules have occurred quietly or without the attention of mainstream media. Taken together, the rule changes are striking in their reckless disregard for the safety and soundness of a sector that blew itself up just 12 years ago, taking the U.S. economy and U.S. housing market down with it, while getting propped up with the largest taxpayer and Fed bailout in U.S. history.

Today’s House Memorandum contains one paragraph regarding the de-regulation of derivatives (swaps) that should send a shiver down the spine of every American. It reads:

“Swap Margin Rule. The Dodd-Frank Act required most swaps to be cleared, with margin required. Margin is also required for uncleared swaps involving financial institutions whose primary regulator included one of the three banking regulators. Initial margin is the amount of margin posted when the swap is entered into, while variation margin is changes in the amount of margin posted over time to reflect changes in the underlying swap’s value. In June 2020, these regulators issued a final rule modifying the 2015 swap margin rule, exempting uncleared swaps with inter-affiliates from initial margin requirements, while keeping variation margin requirements. Fed Governor Brainard argued that the rule would significantly weaken a key capital requirement for the largest banks.”

The House Financial Services Committee has gotten lost in the high weeds. The issue here should not be about posting margin; the screaming issue is that federal regulators would be insane enough to allow an affiliate within one of the serially-charged Wall Street banks to be acting as a derivative counterparty to another affiliate of the same bank.

The whole purpose of having a counterparty to a derivatives trade is that there is an outside party with the financial wherewithal to make good on that trade.

Making sure that Wall Street banks couldn’t again bring down big financial institutions with derivatives as occurred 2008, is why the financial reform legislation known as Dodd-Frank that was passed by Congress in 2010 required the majority of derivatives to be centrally-cleared by a properly capitalized and approved central clearing facility. This was to be accomplished by 2012. It is now 2020 and this stated legislative intent of Congress has been brazenly ignored by regulators and the big Wall Street banks.

According to the most recent report from the regulator of national banks, the Office of the Comptroller of the currency, this is where things stood as of June 30, 2020:

“In the second quarter of 2020, 40.3 percent of banks’ derivative holdings were centrally cleared…From a market factor perspective, 50.7 percent of interest rate derivative contracts’ notional amounts outstanding were centrally cleared, while very little of the FX derivative market was centrally cleared. The bank-held credit derivative market remained largely uncleared, as 36.0 percent of credit derivative transactions were centrally cleared during the second quarter of 2020.”

Let that sink in for a moment. The most dangerous derivatives – credit derivatives that mainly consist of credit default swaps – are only 36 percent centrally-cleared a decade after the passage of Dodd-Frank…

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