Rebuilding the Conveyor Belt of Risk: Unregulated Derivatives and the Erosion of Financial Governance

This podcast episode delves into the persistent dangers of unregulated derivatives, arguing that the financial system has effectively rebuilt the "conveyor belt" of risk that led to the 2008 financial crisis. The discussion centers on a paper by Michael Greenberger, which details how major US banks have systematically evaded the Dodd-Frank Act's protections, particularly its extraterritorial provisions. By utilizing loopholes like the "de-guarantee loophole" and the "assigned-negotiated-executed" (ANE) loophole, these banks move high-risk derivatives trading to foreign subsidiaries, often in jurisdictions with lighter regulation, despite being headquartered in the US and benefiting from the "too big to fail" implicit guarantee from US taxpayers. The core argument is that this evasion undermines the intent of Dodd-Frank, which aimed to prevent future taxpayer bailouts by mandating reporting, clearing, exchange-trading, capitalization, and collateralization for swaps.

The episode highlights key distinctions and nuances in the regulatory landscape. It explains how "naked credit default swaps," essentially unregulated insurance on assets not owned, were central to the 2008 meltdown, enabled by a 2000 law that deregulated them. The industry's strategy involves creating complexity and actively concealing information, making it difficult for regulators and the public to understand the true extent of the risk. The speakers emphasize that while Dodd-Frank sought to address these issues, the financial industry, through powerful lobbying and legal maneuvering, has found ways to circumvent these rules, effectively returning to a pre-crisis state of regulatory arbitrage where banks seek out the "lightest touch" regulation globally.

Practical insights and recommendations focus on the urgent need for action outside traditional federal regulatory channels. Given the current political climate, which favors deregulation, the paper proposes that state attorney generals and state financial regulators can leverage the Commodities Act to sue over violations that adversely impact their citizens. This approach is presented as a crucial alternative, though it faces significant challenges due to the widespread lack of understanding of the complex derivatives market. The speakers stress the importance of public education and support for organizations fighting against financial deregulation to provide a counterweight to the industry's immense lobbying power.

The broader implications extend beyond financial stability to the very fabric of American governance and public trust. The episode connects the financial crisis and subsequent regulatory failures to a deterioration in faith, legitimacy, and trust in American institutions, manifesting in movements like Occupy Wall Street and the Tea Party. It draws historical parallels, with Paul Volcker noting that many current issues, such as regulatory competition and the influence of lobbying, echo problems from decades past. The discussion underscores the moral hazard of the "too big to fail" subsidy, which incentivizes banks to take on excessive risk, and calls for a fundamental re-evaluation of the industry's structure rather than merely adding more complex rules, advocating for a simplification of the industry itself to mitigate systemic risk.

nobody can deny that derivatives were at the core of causing the crash derivatives were time bombs laid throughout the financial system and at the same time they were a conveyor belt that delivered those time bombs throughout the global financial system

this paper talks about how that conveyor belt has been rebuilt by subterfuge by an industry committed to evading the most sensible modest and fundamentally necessary protections

credit default swaps in 2000 were put outside the boundaries of law they were unknown financial regulators had no idea what was going on they were not capitalized there were no anti-fraud protections

dodd-frank set up a regulatory regime for swaps they had to be reported they had to be cleared they had to be exchange-traded there had to be capital set aside they were collateralized

if a subsidiary of a US person or US bank holding company is guaranteed by the bank that if the subsidiary fails the bank holding company will stand behind its obligations dodd-frank applies even though it's foreign

the real guarantee is by you the United States taxpayer the expectation is if the bank holding company fails because bad practices by its subsidiary even though the subsidiary may not be legally guaranteed that the bank will be rescued

the commodities Act gives state attorney generals and state financial regulators the right to go into federal court to sue over violations that they can show will have an adverse impact on the citizens of the state

it is the least understand understood of all the financial markets not because it's so complicated but because everything has a confusing name associated with it

too big to fail is a huge subsidy it allows you to take on marginal risk young what you would otherwise take because your counterparty your creditor if you will is confident that you'll be bailed out