The Senate Agricultural Committee passed its Chair Blanche Lincoln's (D-AR) bill to revamp the derivatives market today. It will now take the place of the derivatives section in the Banking Committee's broader reform legislation. Lincoln's bill is the most aggressive attempt to date for reforming the shadowy world of Wall Street's most complex securities. It seeks to cast light in some of those dark corners so that investors and regulators can better understand the derivatives market. The sentiment is sensible, but not all of the ideas contained in the bill are as uncontroversial as they appear. One problematic suggestion: requiring virtually all derivatives to be cleared.
Currently, several clearing houses exist for derivatives. They act as sort of middle men that net out derivative obligations and ensure that all parties eventually get what they're owed, depending on how the derivatives perform. This might sound great, but mandatory clearing will impose a cost on the market.
The problem can be understood through an analogy. A clearing house is kind of like a bookie that takes bets, but doesn't set odds. Let's say Nick wants to bet that the New York Knicks will beat the Miami Heat. But another guy, Heath, thinks the Heat will win. They both contact a bookie named Clarence. If Nick knows Heath, then they could just bet each other, without Clarence's help. But if they make the bets through Clarence, then he will ensure that each party gets its winnings. A clearing house makes a similar promise to both investors in a derivative.