The government has allowed the amount of derivatives to reach 1.2 quadrillion dollars.
What is the government doing for an encore? Bailing out the derivatives clearinghouses.
As the Wall Street Journal reported Thursday:
(The government has actually been backstopping derivatives for some time).
Little noticed is that on Tuesday Team Obama took its first formal steps toward putting taxpayers behind Wall Street derivatives trading — not behind banks that might make mistakes in derivatives markets, but behind the trading itself. Yes, the same crew that rails against the dangers of derivatives is quietly positioning these financial instruments directly above the taxpayer safety net.
The authority for this regulatory achievement was inserted into Congress’s pending financial reform bill by then-Senator Chris Dodd.
Specifically, the law authorizes the Federal Reserve to provide “discount and borrowing privileges” to clearinghouses in emergencies.
To get help, they only needed to be deemed “systemically important” by the new Financial Stability Oversight Council chaired by the Treasury Secretary.
Last year regulators finalized rules for how they would use this new power. On Tuesday, they began using it. The Financial Stability Oversight Council secretly voted to proceed toward inducting several derivatives clearinghouses into the too-big-to-fail club. After further review, regulators will make final designations, probably later this year, and will announce publicly the names of institutions deemed systemically important.
We’re told that the clearinghouses of Chicago’s CME Group and Atlanta-based Intercontinental Exchange were voted systemic this week, and rumor has it that the council may even designate London-based LCH.Clearnet as critical to the U.S. financial system.
U.S. taxpayers thinking that they couldn’t possibly be forced to stand behind overseas derivatives trading will not be comforted by remarks from Commodity Futures Trading Commission Chairman Gary Gensler. On Monday he emphasized his determination to extend Dodd-Frank derivatives regulation to overseas markets when subsidiaries of U.S. firms are involved.
If there’s one truth we’ve learned about government financial backstops, it’s that sooner or later they will be used. So eventually taxpayers will have to bail out one derivatives clearinghouse or another. It promises to be quite a mess.
Indeed, Nobel prize-winning economist George Akerlof demonstrated that if big companies aren’t held responsible for their actions, the government ends up bailing them out. So failure to prosecute directly leads to a bailout. Bailing them out- in turn – creates incentives for more economic crimes and further destruction of the economy in the future.
As financial incentive expert William Black notes, we’ve known of this dynamic for “hundreds of years”.
Note: It’s not just banks. The government has bailed out hedge funds and companies like McDonald’s and Harley-Davidson.
Indeed, drug dealers kept the banking system afloat during the depths of the 2008 financial crisis. So are the biggest drug cartels “systemically important” and “too big to fail”? Will the U.S. government backstop the Colombian drug lords?
Sure, their actions don’t help society, and instead harm a lot of people. But so do those of the giant banks speculating in derivatives.
And there may be more overlap than admitted in polite company.