Derivatives Market Still an Opaque Moneymaking Scheme for Big Banks

In the bad old days before the Dodd-Frank Wall Street Reform and Consumer Protection Act, major Wall Street players oversaw a massively opaque market in derivatives contracts where Wall Street middlemen made undisclosed profits by acting as intermediaries between buyers and sellers. Here’s the story as told by The New York Times:

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

Now that regulatory reform has been made law, the market promises to be much more trans — oh, wait! Not exactly. A group of representatives from big Wall Street firms like Goldman Sachs, Morgan Stanley and JPMorgan Chase get together to set the rules for a new derivatives clearinghouse that is supposed to foster transparency and reduce risk. The derivatives market includes much-maligned credit default swaps, the credit insurance contracts that helped enfeeble the financial system — and the outcome of Dodd-Frank has been to anoint certain members of the financial services industry with the power to help reduce CDS risk to U.S. firms. For the most part, though, the team of secret derivatives overseers seems to have worked to keep competitors out of the market.

Critics now say the banks have an edge because they have had early control of the new clearinghouses’ risk committees. Ms. Taylor at the Chicago Mercantile Exchange said the people on those committees are supposed to look out for the interest of the broad market, rather than their own narrow interests. She likened the banks’ role to that of Washington lawmakers who look out for the interests of the nation, not just their constituencies.

“It’s not like the sort of representation where if I’m elected to be the representative from the state of Illinois, I go there to represent the state of Illinois,” Ms. Taylor said in an interview.

There’s also reason to believe that the major banks will have ultimate say in what kinds of contracts go through the clearinghouse and what kinds continue to be undisclosed contracts.

Regulators will have the final say. But banks, which lobbied heavily to limit derivatives regulation in the Dodd-Frank bill, are likely to argue that few types of derivatives should have to go through clearinghouses. Critics contend that the bankers will try to keep many types of derivatives away from the clearinghouses, since clearinghouses represent a step towards broad electronic trading that could decimate profits.

Sounds like, just maybe, Wall Street firms that stand to profit by sort of pretending to help enact reform legislation are actually subverting the process at the expense of their clients — a shocking revelation, we’re sure.

mtaylor [at] | @mbrookstaylor Derivatives Market Still an Opaque Moneymaking Scheme for Big Banks