I thought of this when reading a report in Crain’s this week of how, surprisingly, Citadel CEO Ken Griffin came out in support of Dodd-Frank. The problem is Griffin came out in support of Dodd-Frank months ago, a point we made at the time. And he is not the only one. Other managers and investment professionals have supported putting more restrictions on markets, particularly over-the-counter markets.

This illustrates a problem in modern reporting and perception. We can see a couple of industry leaders or lobbying groups speak out in support or against a new law or policy and jump to a conclusion that said law or policy is universally supported or opposed. We all are guilty of jumping to such conclusions, which are insipid because that is what certain groups want us to believe.

For example, keep on saying that a vast majority of Americans are against health care reform and soon people will believe you.

This really should have no place in reporting but too often it does. Whether it is about legislation, regulation or elections to often the “horse race” story prevails rather than analysis of the details of what is involved. We simply take a survey, and not a very scientific one at that.

I don’t mean to pick on Crain’s here, as their story acknowledges that the remarks were similar to those he made last September, but I think this is a good example of how those pushing an agenda can distort reality and create a false perception. The Chicago Fed event last September was a big deal. And a large and prominent hedge fund supporting a controversial regulatory overhaul was also a big deal. But despite this, it assumes universal opposition by large institutions and free market supporters.

Interactive Brokers boss Tom Peterffy spoket to this in our Top 50 Brokers feature when he stated that the large investment banks were trying to delay implementation of Dodd-Frank until they could gain political support and protect their profits. Peterffy stated in a speech to the World Federation of Exchanges: “The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.”

He goes on to say that at times the banks convince counterparties it is in their best interest.

 “How do they do this? What dark arts do they employ to maintain the status quo? I think their magic consists of such mundane things as million dollar paychecks to the salesmen, golf outings, tickets to games, dinners, Cuban cigars and probably some other blandishments that should not be discussed in polite company. And of course, the fact that most OTC derivatives “customers” are not playing with their own money. The customers are finance or investment staff that work for large corporations, state or municipal governments, pension funds and insurance companies. These end-user employees get to drink the fine wines, but it is the shareholders or taxpayers that pay for the overpriced derivatives.”

This is a vicious circle and the ones making the huge profits are able to convince the media that everyone involved supports the status quo.

Of course Citadel is on the other end of these OTC trades with investment banks, which is why Griffin would like to see a more level playing field. But there and parts of Dodd-Frank for most hedge funds to dislike, so it is easy to get the impression that the industry as a whole is against it in its entirety.

 We all need to pay a little closer attention.

Let’s first consult history. During the recent financial crisis while the Troubled Asset Relief Program (TARP) was shoveling boatloads of billions into the financial community, the regulated clearinghouse needed exactly —$0— TARP dollars. An accident? Luck?  Divine Intervention?

More history.  Many decades ago we Humans noticed that we share many common dangers. Our lives, our health, our homes etc. were at risk. But, instead of saying “every man for himself,” we pooled the risk at modest cost to each of us, and the insurance industry was born.

Clearing does the same thing. All traders contribute to a clearing pool just in case one or more of them defaults. Once a defaulter’s deposits are exhausted, the rest cover the remaining shortfall, which has always been sufficient without ruining them.

The liquidation of Lehman Bros. losses on cleared derivatives trades went smoothly (dealing with the remaining mess continues).

 The cleared derivatives market demands collateral from its users and monitors exposures like a high school hall monitor polices smoking. Falling behind? Pay up NOW or get out NOW.

How can this possibly be a threat to the economy? Are we better off with the old system where staying current on one’s obligation was replaced with a handshake, or a letter of credit from an equally troubled bank, or a keep-well from a parent organization that might perish along with its sub, or a “It’s OK, I met the counterparty’s CEO at Davos and he seemed like a nice guy,” or “Don’t ask Bernie for collateral, the Madoffs have been around for decades”?

 Clearing is a light-years improvement over the slap-dash prior regime. If pooling risk for everyone’s protection is bad, I have a number of insurance policies I need to cancel.

Philip McBride Johnson is a former CFTC chairman and long-time observer of the industry. You can reach him at philipmcbridejohnson@gmail.com

The CFTC recently began releasing rule proposals to fulfill its mandate from Dodd-Frank. Among the first set delivered to the industry for comment was a proposal to limit conflicts of interest in swaps clearinghouses by setting ownership limits. While it initially sounds good, a number of people have spoken out against the proposal. According to Gary DeWaal, general counsel at Newedge, ““If two or three dealers can come up with a great idea and bring something innovative to the clearing front, why should they be prohibited? Let the marketplace decide whether they like that or not. There’s already a tremendous concentration in the United States in the clearing space and anything that discourages competition at this point is a negative.”

It is an issue clearinghouses are looking very closely at, as was evident in Michael Cahill’s, president & chief executive officer of Options Clearing Corporation, comments at the FIA panel. “This would require quite a bit of change in a governance, ownership and board structure that has worked very efficiently for nearly 40 years,” he says.

There is still a long way to go before the proposed rule becomes law. Ultimately, the CFTC and SEC are attempting to make the markets a more secure place. Perhaps costs just need to be considered more closely. “[We hope] the type of rules and regulations we get out of Dodd-Frank ultimately serve us all best, foster competition and don’t produce any unintended consequences or costs,” Timothy Doar, managing director of risk management at CME Group, said at the panel.

One thing the futures industry has continued to do is grow. As swaps are coming under much of the same regulation as futures, there is sure to be some growing pains that need to be worked out. According to Thomas Hammond, president & chief operating officer at ICE Clear U.S., one thing is sure, “The futures industry has always prided itself on innovation.” That innovation just needs to extend a little further now.

The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) held a joint round table discussion to gather views from panelists as the two regulators move to start writing rules governing swaps.  Gary Gensler, CFTC chairman, released a short statement before the round table saying, “Requiring swaps to be traded on regulated trading platforms will bring transparency and better pricing to the derivatives markets. This will lower risk and costs for businesses. I look forward to hearing panelist views at today’s round table to inform our rule-writing in this area.”

Panelists were mostly in line with what Gensler is hoping to see transpire, although there was still room for discussion on how SEFs and SB SEFs will operate. Much of that discussion centered around concepts of “fairness,” especially as it pertains to exchange access and disclosure.  While some advocated open access to anyone, many argued for minimum standards to be put in place, much like those in place on futures exchanges like CME Group.  They argued that while this move will mutualize counterparty risk, it will not eliminate it, so the SEFs should work to minimize possible risk.

Panelists stressed, though, their desire to see clear and objective standards put into place.  Instead of leaving things to be subjectively decided, most called for clear lines to be drawn to handle eventualities like how a firms growth will be viewed as well as the procedures for breaking trades and removals from the exchange. While there was an understanding that these markets will change and evolve over time, the prevailing desire among panelists seemed to be for clear answers and concrete guidelines. Not surprising considering the period of volatility, fear and often panic we recently saw.

The regulators have a big job in front of them as they have to define almost everything in this previously secretive over-the-counter market, beginning with determining what a swap is and which will be on what exchanges. Those are the questions that will have to be answered first, before questions of disclosure and registration can be definitively answered. To meet the deadline for new rules, the regulators have said they hope to have proposals of the rules drafted by mid-December.

But there are big changes and challenges ahead for the OTC market, as new reforms passed by the Senate will require most OTC derivatives contracts be traded on exchange and cleared.  Issues surrounding central clearing and exchange trading, according to the report, will include determining ownership of clearinghouses, trading requirements and exceptions and capital and margin requirements. When discussing upcoming efforts to harmonize the Commodity Futures Trading Commission and Securities and Exchange Commission and give them the authority to regulate OTC derivatives, the report states: “If done correctly, it could help simplify the regulation of these markets. If it is not done correctly, market participants fear that regulatory confusion will create a difficult-to-navigate environment muddied by redundant bureaucracy.”

I was expecting an arid presentation in Ben Stein mode, but it was not to be. Gensler was lively and witty. He stood firm on his conviction to regulate the OTC markets, equating what these instruments did to our financial system to what Mrs. O’Leary’s cow did to Chicago in the Great Fire. He shared barbs with John Damgard, the FIA president who is renown for his humor, answered questions from a somewhat hostile audience straightforwardly and even commended them for how they weathered the financial crisis. “While no TARP money was used to cover market exposures on cleared futures transactions, AIG had to be bailed out in part to cover uncollateralized and uncleared derivatives contracts,” he said in his speech.

This speech wasn’t breaking news. He has used the Chicago fire metaphor before, stating that the result was stronger building codes. And he’s said repeatedly that the multi-trillion dollar OTC market remains largely unregulated and the most important parts of financial regulation must include that largely “standardized” OTC derivatives be centrally cleared and that dealers be regulated. Gensler stated “In some cases, even when a dealer may have been part of the larger regulated financial institution, its derivatives business was not explicitly regulated.” AIG’s financial derivatives group is a good example. Gensler believes requiring those groups to have sufficient capital, post collateral on transactions and be “subject to stringent record-keeping requirements” would prevent the out-of-control trading on the other 20-25% non-standardized OTC derivatives.

Of course he brought up the whole “transparency” issue, but I’ve become cynical of this push, especially as hedge funds are no more “transparent” today than they were after Long-Term Capital Management or Amaranth. And surely there are rules and regulations in place that require that a company must be diligent in its oversight. AIG’s derivatives unit was making insanely large profits to the dismay of other units within the firm that weren’t living up to the bewitched corporate heads. Haven’t we seen this before in Barings, or a better example, Enron? High returns typically mean high risk is taking place. So what the hell were the overseers of AIG doing? Lehman Brothers is another example of Wall Street leadership largesse: according to the court-appointed examiner, allegedly Lehman chief Richard Fuld goosed the financial statements to show better results.

Although I applaud Gensler’s somewhat reasoned approach to regulate a large, unwieldy and highly lobbied group, especially when it’s a world he came from (Goldman Sachs), I’m still dubious. Seems to me the “smartest guys in the room” were doing their job: making money for the company. If they were committing fraud, they should go to jail. Period. But for Congress to work around the system to make it look like something is being done is flawed. The focus should be on the top executives and boards who were collecting checks while looking the other way. To use Gensler’s metaphor, ignoring the leadership oversight issue would be like new building codes that demand brick structures be built, but turn a blind eye to the inspectors who ignore poor wiring because they get a piece of the action.

Of course there was the increase in financial requirements for futures commission merchants (FCM) and retail forex exchange dealers (RFED), which was upped to $20 million, plus 5% of the amount, “if any, by which liabilities to retail forex customers exceed $10 million.” There was the new boilerplate disclosure rules, as well as the new required registration of FCMs and RFEDs and their associated persons. These were all expected and huffed about, but accepted as a way to keep OTC forex for retail open in a period where on-exchange has become the new black. What wasn’t expected was the leverage rule, that is, leverage in retail forex customer accounts would be subject to a 10-to-1 limitation. This would be far different than the current 100-1 level that just went into effect last year.

To put this in perspective, if you wanted to trade a contract of $100,000, today you need only $1,000 in your account. With the 10-1 rules, you would need $10,000. This basically raises the margin level from 1% to 10%. In comparison, the National Futures Association (NFA) required a 100-1 limit. A futures exchange contract can vary in leverage from 20-1 to 50-1 per contract, depending on currency and volatility (see Trendlines).

The anger from the RFEDs and FCMs was loud and clear: they will be out of business or have to flee to kinder regulatory shores if this proposal passes. Their customers were more blunt: try prying 100-1 leverage from their cold, dead hands. Seriously, in reading through of the comment letters thus far, this rule has taken on a Tea Party-esque aura in which people are ready to pick up arms to defend their right to trade. Here are some examples from comment letters:

“This country is supposed to be run ‘by the people’ which is a concept that seems to have been lost since 1776. Our forefathers would be appalled if they could see what is happening to their country – they wouldn’t recognize it as every day we lose a little more freedom.”

Or: “As an investor and active retail forex trader, I expect the freedom and right to choose the amount of leverage that is appropriate for my desired risk…”

Or: “Last summer the NFA ‘tweaked’ things…and now it’s as though Pandora’s Box has been opened so you too have to get in and change something that has been fine for 20 years.”

Or: “On the subject of regulating retail forex, plain and simple…STAY OUT OF TRYING TO RUN MY PERSONAL LIFE!!!!!!”

And another: “You are out of your cotton-pickin’ mind. I want to know the name of the communist who has proposed this legislation…..”

In fairness, although all the comments were passionate, most were reasonable, stating how this 10-1 ruling would affect their business and personal trading. Many thought the earlier reduction to 100-1 from 200-1 was acceptable, but this had taken it too far and would either force them to move off shore or quit trading OTC forex.

The day the rule was proposed, I ran into someone in the business who has his finger on the pulse of regulation. He shook his head when I asked how the CFTC came up with 10-1. “I don’t have any idea,” he said. “Seems like they pulled it out of the air.” Or from somewhere else, or so OTC retail traders would say.

She says with the current proposal there’s the potential to damage legitimate traders and that killing the market would not solve the fraud problem.

Daniel Waldman, partner at Arnold & Porter LLP and former general counsel at CFTC, says that although it’s uncertain what form pending legislation will take, that regulatory changes ARE coming. He says that the bottom line is that we will see new legislation and traders, therefore, need to follow developments on the regulatory front.

Brown-Hruska agrees, saying that the trading community “needs to make their voice heard” as new regulations are set to change the way they do business.

For more from our Washington insiders, including background and details on pending legislation, check out our feature story in the April issue.

House Agriculture CommitteeChairman Collin Peterson (D-MN), whose Peterson-Frank Amendment to HR 4173, passed by the House in December, established a central clearing requirement for OTC derivatives, says, “the way our legislation is crafted right now, you will see a lot of [OTC products] standardized, 70%-80% of this stuff will be standardized.” He mentioned how the House Ag Committee is working with European regulators and that CFTC Chairman Gary Gensler is focused on coming out with harmonized international regulation. 

Peterson  doesn’t believe position limits will force trading overseas and said big banks should be subject to the same position limits as speculators. In response to traders who say new regulations could impede the way they do business, he said, “it will affect the way they do business, and it should. Our economy got built up based on all of this money, and it was a false economy, and now we’re getting down to a real economy. To get to the real economy, it’s going to mean less business [for traders and banks]. They’ll survive.” He says OTC market regulation was the most important regulatory issue at the moment, along with making sure banks have adequate collateral. “The OTC market is so huge and it’s got to be brought out in the open.”

Next, we talked with CFTC Commissioner Jill Sommers about the issue that’s come under much criticismfrom the forex industry, CFTC’s recent proposal to reduce leverage for OTC forex firms to 10:1. “We don’t have a response yet; that’s the purpose of putting it out for comment. We’ve been working on this proposal for a number of months.” Obligations for CFTC to write rules in this area came in May of 2008 with the passage of the Farm Bill. “When you put a proposal out for comment, there’s always going to be parts of the proposal that the industry has concerns about and that’s the purpose of putting something out for comment.” Staff will review comments and will come to Commission with analysis of views and recommendations for a final rulemaking. She says final rulemaking is “several months away.” The comment period ends March 22. Sommers also said that she “does not have knowledge” about how the CFTC arrived at the 10:1 leverage calculation.

Stay tuned for reaction from Washington insiders including former CFTC Chairman Sharon Brown-Hruska, and for our larger feature on regulation, coming up in the April issue.