Markus Stanley: Derivative bets not a zero sum game, have far reaching real
PAUL JAY, SENIOR EDITOR, TRNN: Welcome to The Real News Network. I’m Paul Jay in Baltimore.
After the crisis in 2008, many of us became aware of some language, a vocabulary we hadn’t heard beforeâ€”derivatives, credit default swaps, synthetic bets, this whole dark market that now involves, according to one academic, perhaps as much as $1Â quadrillion. So what’s $1Â quadrillion look like? Well, take a look at these graphics. These are done by kokogiak.com. Here’s what $1Â trillion looks like if you put it into a queue next to the Empire State building or the Sears Tower. Okay, that’s $1Â trillion. Well, here’s what $1Â quadrillion would look like. Yeah. Enormous. So $1Â quadrillion dollarsâ€”it boggles the mind. This means that it’sâ€”the size of the derivatives market is something like 20 times the value of all products produced on the planet.
Well, people say, well, if this is so big and have such enormous implications to the global economy, it should be regulated. And that’s a subject of our interview today, ’cause there’s a big battle going on about whether or not this market will be regulated, and if so, how.
Now joining us to talk about all of this is Markus Stanley. Markus is the policy director of Americans for Financial Reform, which is the main public interest coalition working for stronger financial reform. He previously worked as a senior economist at the U.S. Joint Economic Committee and as an assistant professor of economics at Case Western Reserve University. Thanks very much for joining us, Markus.
MARCUS STANLEY, POLICY DIRECTOR, AMERICANS FOR FINANCIAL REFORM: Thank you, Paul.
JAY: Alright. So these market numbers are, like, crazy. I mean, just to be clear, when we’re talking about quadrillion, we’re talking about what people call the notional value, not the actual cash involved in these bets. So maybe you could just quickly explain that and then get into just how big this is, and then we’ll get into the regulation issue.
STANLEY: Yeah. Well, essentially, derivatives are bets on the value of something else, and usually it’s a stock or a bond, a security, an interest rate. And essentially what notional value is is the size of the thing that you’re betting on. So the actual amount you have to pay might be only a fraction of that size. But as you said, this market is so enormous compared to the global economy that the amounts of money that are at stake to be paid are very, very large and have extraordinary implications for the financial system.
JAY: Yeah. And while these bets areâ€”you know, thereâ€”some pool of money bets against someone else who controls another pool of money, and one wins and one loses. It’s not really a zero-sum game, is it? Because they’re betting on real things, even if they don’t own those things. So they could well be betting on the price of rice or corn or fuel or oil, or even as ridiculous asâ€”one of the derivatives plays is now they can bet on whether a movie’s going to make money or not. But the thing is, if you’re betting, for example, the movie won’t make money and you happen to own a media company, it’s certainly in your interest to see if that movie gets bad reviews. And even more importantly, if you’re betting on the default of a bank and you’re another bank, then if you can do something to push that other bank into default, you make money. And that’s actually happened, hasn’t it?
STANLEY: Well, there are a lot of accusations in 2008 that exactly that happened, that that did happen when institutions were teetering at the brink and some traders had credit default swaps. Then they would have an incentive to sort of push them over the edge.
And I think there are two things people say as though they’re equivalent, but they’re actually not the same at all. One is that these areâ€”that this is a zero-sum game, which in some sense isâ€”which is true in the following sense, that anyone who pays something on a derivatives contract, if one person loses, another person is supposed to gainâ€”someone else was getting that money.
But then the other implication that people draw is that there’s no real-world consequence. And that’s completely wrong, because as you say, you know, in theseâ€”these bets can create incentives for all kinds of real-world activities that can be very harmful, and also these bets can create bankruptcies, and they can create the failures of institutions in the financial system. And when those bankruptcies happen, then that’s very disruptive to the whole system, because once a bankruptcy happens, you know, you may not have another party there to pay off on the bets you made, and that can be very disruptive all up and down the line.
JAY: Well, and it can also involve people’s pensions and savings, and very real-world consequences for a lot of ordinary people.
STANLEY: In fact, pension funds are quite invested in a lot of derivatives products. So it can very definitely involve people’s pensions.
JAY: Okay. So the size of this, scope of this is enormous. To what extent is it regulated, and where are things at in the regulatory battle?
STANLEY: Well, before 2008, this market was almost completely unregulated, or it was self-regulated by the banks, which, as we’ve seen, is not really a good model. And that was a very dangerous situation, as we saw. And in the Doddâ€“Frank Act, which was passed in 2010 as a response to the crisis, for the first time Congress passedâ€”mandated that this market be regulated. And that was a mandate for the United States derivatives markets. And the other major countries around the world agreed in principle that they also would regulate their markets.
And the regulation was very basic. It revolved around three things, first of all, that people had to reserve some money to make sure that they could pay off their derivatives bets in case anything happened. So that’s a very straightforward, common-sense kind of thing to do. Also, that this market had to be transparent, that these trades had to be reported to regulators, so that people understood the risks that were going on, and also that they be traded in open competitive exchanges, where it was possibleâ€”so those are, you know, like the stock marketâ€”so that this market wouldn’t be in the shadows in the way it was before. So these are really very basic reforms.
But the problem is that since thisâ€”it’s one thing to pass a law, but it’s another thing to implement it. Since this law has been passed, it’s come under ferocious attack by industry, by the financial industry, by the financial industry’s friends in Congress. And we’ve seen a lot of success in delaying and attempting to derail the actual implementation of these laws, and that’s involved every anything from lawsuits to proposed new laws that would put loopholes in this, to big-money lobbying, to attacks on the funding of the regulators who would have to enforce this.
One of the main regulators that’s going to be enforcing these rules for this $700Â trillion global market, or even larger, as you pointed out, is the Commodity Futures Trading Commission, which is funded at $200Â million, $200Â million. And that is, you know, tiny compared toâ€”they really only have a couple of hundred staff to regulate this enormous global market. And there’s been a lot of pressure to keep their budget down in order to prevent effective regulation.
JAY: Now, one of the other things that’s happening is there’s a battle overâ€”as weak and as many loopholes as might end up being in this legislation, there’s a way around all of it, which is simply American banks through subsidiaries can conduct these derivative plays offshore. And Americans for Financial Reform, you’ve been pushing that there has to be some form of regulating that. So where is that at?
STANLEY: Yeah. And I should say in reference to what I said before, we have had some success in pushing back some of these attacks. We’ve managed to stop all the new laws in Congress that would have put loopholes in this, and we have managed to make some progress in some areas toward implementing this. So we are moving toward implementation.
But one of the things that we’re really worried about is that the big banks are trying to exempt their foreign affiliates, basically, from U.S. derivatives regulation. And this is very dangerous, because derivatives areâ€”you know, the modern financial world works on computer, you know, and it’s very, very easy to transfer the liabilities for these bets all over the world at the touch of a computer keyboard. And there really is no place to derivatives. These banks have hundreds and sometimes thousands of foreign affiliates, and it’s extraordinarily simple for them to move a derivatives bet or a derivatives exposure from their United States affiliate over to an affiliate in Singapore, Hong Kong, London, you know, the Cayman Islands.
And we’ve seen this happen over and over again. AIG, whichâ€”people probably recognize that we had to do a giant taxpayer bailout of AIG’s derivativesâ€”those derivatives were run out of London. If anyone remembers Long-Term Capital Management, which back in the ’90s almost brought down the world financial system through overloading on derivatives, those derivatives were run out of the Cayman Islands. So it’s very, very important that these rules apply overseas as well as the U.S.
JAY: And where are you in terms of the political parties? I mean, Romney’sâ€”is pretty straightforward. He wants to throw Doddâ€“Frank out, and who knows what he would replace it with. But where’s the Democratic Party and its leadership on this issue about offshore?
STANLEY: Well, you know, when you get down into the technicalities of these issues, there are theâ€”the partisan lines can blur. There’s a lot of money at stake here, and we’ve definitely seenâ€”we’ve definitely seen some Democrats supporting the creation of these loopholes.
And we also seeâ€”you know, we see a fight on the regulatory bodies as to how exactly this is going to be done. And it’s unclear exactly how that’s going to work out. As you said, you know, some people have come out for completely repealing Doddâ€“Frank, which would repeal these derivatives regulations.
And you have to wonder and ask, well, you know, what would happen if that was done? Would we have any regulation of this market whatsoever? But the backroom fight over whether we can force regulation of these foreign subsidiaries is something thatâ€”you know, you can’t take party lines completely for granted. You really have to fight this out in the regulatory agencies and by bringing the details here to people’s attentions and the implications of what some of these exemptions [crosstalk]
JAY: And what about the leadership of the Commodity Futures Trading Commission? Are they in favor of regulating these offshore subsidiaries or no?
STANLEY: Well, they’ve come out with a veryâ€”with a complex guidance, basically. They’ve come out with a rule that goes some distance. Gary Gensler, who’s the chairman of the CFTC, has actually been pretty good on this issue. But there are five commissioners, and you’ve got to get three out of five votes. And they’ve come out with a guidance that goesâ€”takes some steps toward regulating these foreign affiliates but has some significant loopholes.
And two of the loopholes are, first of all, that they would permit what’s called substituted compliance, so that you wouldn’t have to comply with U.S. rules. You could comply with the rules of the jurisdiction that you were in, and there would be some attempts toâ€”the jurisdiction you are in would have to have some rules, but they might not be as good as the United States’.
JAY: Well, it could be Cayman Islands, which would mean not many rules at all.
STANLEY: Yeah, the historical record of the CFTC on this kind of substituted compliance has not been great, and they’re giving some lip service, oh, we’ll look, we’ll make sure that these rules are just as good. But it’sâ€”you know, we’re very skeptical of that, and we really have to hold their feet to the fire to limit this kind of substituted compliance, and also to make sure thatâ€”basically, to make sure that these guys are following real rules anywhere in the world they are.
And the second loophole, which could be just as big, if they said that, well, if you have an affiliate and you haven’t guaranteed the transactions of that affiliate, in other words, the U.S. parent is not going to beâ€”is totally not going to be responsible for the derivatives transactions of that foreign affiliate, then in that case it’s okay, we can treat that foreign affiliate as though it’s not part of you, and it won’t be regulated. And that’s a huge, huge problem, because it’s very, very difficult to tell whether these foreign affiliates are guaranteed.
I mean, if I have an affiliate and I call that J.P.Morgan Cayman Islands, there’s a reason I call that J.P.Morgan Cayman Islands. The people I’m dealing with are expecting that I’m going to pay off the liabilities of that affiliate. You know. And we saw that in 2008. Bear Stearns went bankrupt because, you know, hedge funds that it had not technically guaranteed, it had to pay off their debts because the market demanded it. Basically, the market said, people in the market said, if you can’t pay off these debts, you know, I’m going to stop lending to the parent company.
So this issue of whether a foreign affiliate is guaranteed is really notâ€”I mean, any major foreign affiliate of a U.S. bank that’s dealing in derivatives almost certainly has at least an implicit guarantee. I mean, that’s how banking works. It’s all about trust and implicit guarantees. So that could be a huge loophole as well.
So these two issues, you know, whether you could take the foreign rules and have that apply to you, in which case we could see these regulatory havens starting to emerge, and whether you can tell the regulators that, oh, this foreign affiliate is unguaranteed, don’t worry, I won’t have to pay any of its debts, you know, and whether you can get it so you don’t have to regulate me, you can ignore what I’m doing, those are very important issues that could be really central to whether derivatives rules work.
JAY: Alright. Thanks very much for joining us, Marcus.
STANLEY: Okay. Thank you, Paul.
JAY: And thank you for joining us on The Real News Network.
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