Toothless Regulator Looks to Take a Bite Out of Derivatives

When President Obama unveiled his regulatory overhaul plan [1] last week, the Commodities Futures Trading Commission, or CFTC, dodged a bullet.

Lacking power, the agency has only gently regulated the derivatives markets, which have been blamed for wreaking havoc on the global economy. Rather than abolish the agency, however, Obama proposed strengthening it. A week later, not all reformers are convinced that the plan is comprehensive enough and, more so, doubt the CFTC is capable of recovering from its long legacy of deregulation.

A look back at that legacy explains the skepticism. "The CFTC was left with the responsibility for policing fraud and abuse and had no tools to do that," said Barbara Roper, the director of investor protection for the Consumer Federation of America.

The agency's reputation has been so damaged that shortly before Obama's announcement, the administration signaled that the CFTC and SEC would join forces [2]. (The two agencies currently split oversight of derivatives). But the merger never made it into the final plan. It met opposition in Congress, where the CFTC still maintains strong allies on the agricultural committees. So Obama instead asked the two agencies to reconcile their differences and cover holes in their oversight. This week, in a move that pleased many advocates of financial reform, they released a blueprint for greater regulation of derivatives.

The CFTC's job was not always so complicated. The agency was created in 1974, primarily to oversee commodity futures contracts. This type of derivative allows investors to buy a commodity, often an agricultural product like wheat, at a fixed price and date. Soon the futures industry expanded beyond commodities, making it more complex and harder to control. But the CFTC lacked the teeth and size to take on new responsibilities. And some in the agency who had close ties to industry wanted it that way.

In the 1990s, the CFTC began allowing many privately negotiated derivatives, or so-called over-the-counter contracts, to escape regulation. Wendy Gramm, CFTC chair from 1988 to 1993 and wife of former Texas Senator Phil Gramm, supported a rule change in 1992 that loosened the energy trading industry for companies like Enron. Sheila Bair, then a commissioner at the CFTC and now director of the FDIC, cast the lone dissenting vote at the commission, saying the plan "sets a dangerous precedent." Five weeks later, after resigning from the CFTC, Wendy Gramm joined Enron's board of directors.

The gig was lucrative. According to the watchdog group Public Citizen, over the course of the following eight years, Enron paid her between $915,000 and $1.85 million. Enron also contributed more than a hundred thousand dollars to Phil Gramm's campaign fund over the years, according to the Center for Responsive Politics. And they had plenty of that kind of money to spread around. Companies like Enron were now able to trade energy futures outside regulated exchanges.

While lucrative, in the short term, for firms like Enron, the lack of oversight was calamitous for others. Orange County, Calif., declared bankruptcy in 1994 after it lost $1.6 billion in derivatives trading. Shortly after that, the U.S. General Accounting Office urged Congress to increase oversight over derivatives. (PDF)

But the Hill went the other way, preventing the CFTC from regulating over-the-counter derivatives altogether.

Then something unexpected happened: The CFTC got a leader who believed in greater regulation. In 1998, the new chairwoman, Brooksley Born proposed a crack down on derivatives. In a recent interview with the Washington Pos [3]t, Born described how she woke repeatedly "in a cold sweat," forecasting our current financial meltdown. "I was really terribly worried," she told the Post. But her concerns met fierce opposition from Fed Chair Alan Greenspan, the Treasury Department and others.

According to news accounts, Sen. Richard Lugar, an Indiana Republican and former chairman of the Senate Agriculture Committee, wrote a letter urging Born to "avoid any unnecessary interference in these productive and healthy markets." And, so, the problem got even worse.

Led by Phil Gramm and Lugar, Congress passed the Commodity Futures Modernization Act of 2000 [4], which allowed the trading of even more exotic derivatives outside the purview of the CFTC. "Born was treated pretty disgracefully," said Roper, of the Consumer Federation of America. "If I were in her position today, I'd be screaming ‘I told you so.'"

One person who might have deserved Born's scrutiny is Gary Gensler, a former partner at Goldman Sachs, assistant Treasury secretary under President Clinton and the current chairman of the CFTC. Gensler, who once opposed derivatives regulation, beat back CFTC oversight when he helped shape [5] the Clinton administration's response to Born's proposal. But now, in the wake of the financial meltdown, Gensler has changed his tune on derivatives regulation. The SEC and CFTC "should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses," Gensler told the [6] Senate Banking securities subcommittee this week.

At his February confirmation hearing, Gensler said [7] he and other officials "should have done more to protect the American public through aggressive regulation, comprehensive regulation."

Still, Senators Bernie Sanders (I-VT) and Maria Cantwell (D-WA) had put holds [8] on Gensler's nomination, because of concerns over his former deregulatory positions. They eventually released the hold, though Cantwell said she will, "continue to have concerns about Mr. Gensler's appointment."

A CFTC spokesman didn't return our call requesting comment. Michael Greenberger, a former high-ranking CFTC official who once fought Gensler to approve Born's proposal, now is "quite hopeful" that Gensler will be an effective regulator. "For whatever reason, he's been very aggressive at laying out a strong legislative and enforcement program," said Greenberger, now a professor at the University of Maryland School of Law.

Greenberger, who still believes that "in an ideal world" the CFTC and SEC should merge, said Gensler is working "to understand what needs to be done." Of course, looking back on years of "passive" leadership, Greenberger said, there's a lot to be done.