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August 09, 2010

Financial services industry still in denial: “History, get me a rewrite!”

Even before President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, articles and blogs had forecast the circumvention of the law by legions of clever lobbyists for Wall Street—many of them former regulators—through the federal rule-making process to implement the legislation. In more sophisticated techniques of circumvention than mere lobbying, some firms, such as Goldman Sachs, are reorganizing their trading operations and reapportioning their funds, so as to be able to reclassify their trades and thereby reduce regulatory scrutiny of their trade data reporting. For example, by moving personnel and funds from the proprietary trading division (trading on behalf of the firm itself) to the asset management division (trading on behalf of clients), Goldman hopes to circument the Volcker Rule in the legislation against trading with depositor's money, e.g., Federal Reserve funds almost donated by the government at historically low interest rates. It remains to be seen whether the Security Exchange Commission and Commodity Futures Trading Commission will judge the reorganized trading strategy as complying with the expressed will of Congress and the president.

Pecuniary interests, of course, explain part of the desire to remake the law to serve the perceived self-interest of the financial service industry. But underneath is a profound denial of the damage caused by deregulation and failure to enforce financial market regulation. This denial occurs even as the Bank of International Settlements and U.S. Federal Reserve Bank regulators reported in July that Goldman, Morgan Stanley, American Express and CIT were among the banks that underreported their credit derivative risk exposure (sub req.) by $400 billion in the first quarter of 2009, posing yet another systemic financial risk. Those who decry the new legislation as over-regulation do so not just for pecuniary reasons, but for reasons of self-exculpation. In a nutshell, if we can show there was no excessive speculation that triggered a financial meltdown, then there is no reason to re-regulate the financial services industry.

The strategy for denying the need to regulate financial services was aided by the Organization for Economic Cooperation and Development (OECD) in a “preliminary” study published during the last weeks of U.S. Senate debate on the financial reform bill. The study purported to show that excessive speculation did not occur in agricultural commodity futures markets and did not play a role in inducing extreme commodity price volatility. Indeed, the OECD authors claim that commodity index funds, such as those of Goldman and Morgan Stanley, helped to reduce price volatility by buying and selling more commodity futures contracts. Goldman cited the OECD report as proof in rebutting a July Harpers Magazine article by Frederick Kaufman that accuses the firm of  trading practices that increased food prices and led to widespread hunger in developing countries.

The OECD study has been thoroughly debunked by David Frenk and colleagues at Better Markets, Inc. Frenk et al. show that the OECD authors used a statistical analysis method, Granger causality tests, that is explicitly not designed to analyze “extremely volatile dependent variables,” such as commodity prices circa 2007–2008. Furthermore, the OECD attempts to demonstrate that supply-and-demand factors accounted for extreme price volatility is not coherent, according to actual trade data—especially for energy commodities. Despite the convincing rebuttal of the OECD study, we will not be surprised to see the study cited as authoritative by those who consider the new U.S. legislation to portend over-regulation.

Another tactic to circumvent U.S. legislation will be to fight the European Commission's proposal to expand its Market Abuse Directive to cover over-the-counter (OTC) trades that currently are all but unregulated. The weaker the EC regulation, the easier it will be for U.S. firms to continue business as usual in EU markets. The Wall Street reform legislation severely restricts OTC trades (i.e., firm-to-firm transactions whose price information is not reported in time to contribute to price discovery)—a U.S. legal requirement for commodity exchange operations. In a July 23 submission, IATP supported the commission's proposal to expand its rulemaking to cover OTC trades and responded to other questions that will be discussed at a public hearing on commodity derivatives regulation to be held September 21 in Brussels. If the new U.S. and EU financial and commodity market rules are successfully implemented and enforced, the opportunity for the financial services industry to rewrite the history of a decade of deregulation to justify its opaque and unfair trading practices will be greatly reduced.    

Steve Suppan

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