Financial Reform: The Devil Is In the Details

August 11, 2010 06:12 AM

The massive, 2,300-page Dodd-Frank bill that became law on July 21 doubtless will touch the lives of most Americans. The question that is not so clear is "how?" At this time, most analysts believe it will not lead to a wholesale restructuring of the financial business, but it may result in higher costs in the financial industry and possibly some unintended consequences.

"This bill does more to restructure oversight of financial institutions than the way the operate," says John Graves of Huntleigh Securities in St. Louis, Mo. "It gives additional powers to existing agencies and creates a new Consumer Financial Protection Bureau. So we can expect a direct and immediate result will be more government jobs."
A huge question mark is how provisions relating to derivatives will be handled. In the past, such financial instruments were traded outside the exchanges. Under this law, they are to be standardized and cleared through an exchange—with a view toward greater transparency. Depending upon how narrowly derivatives are defined, some worry that certain contractual arrangements between ag producers and their buyers could fall into the category.
University of Illinois ag economist Scott Irwin, who has studied agricultural commodity markets for many years, worries whether the exchanges can handle the potential quantity of such contracts. "This could exponentially increase the number—and types—of contracts to be cleared."
He also cautions that the wording in the bill is such that it is possible that a single futures position that doesn’t strictly fit the hedge category (i.e., that a farmer or trader holds an equal and opposite position in the cash market) could mean a farmer loses his or her hedge status, which has income tax implications. It also means a lower position limit applies, though that won’t affect farmers or probably even the commercial enterprises that buy from them.
Hedge funds with more than $150 million in assets will have to register with the Securities and Exchange Commission. "At most, this may mean large funds fracture into a host of smaller ones to ‘fly under the SEC radar,’" says Dan Manternach, editor of Doane’s Agricultural Report.
However, the bill lowers the standards for "market manipulation," he adds. In the past, the Commodity Futures Trading Commission had to prove:
  1. Prices were above or below what "normal" supply-demand analysis would predict.
  2. The alleged manipulator had the ability to affect the price.
  3. The alleged manipulator performed actions that led to the artificial price.
  4. The alleged manipulator intended to cause a price movement (not just anticipate it).
"Now, CFTC doesn’t have to prove artificial prices have been created. They don’t have to prove an intent to manipulate," Manternach says. "They just have to prove ‘reckless’ trading. Until that is defined, we could see some legitimate trading become more conservative, lessening liquidity and price discovery."


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