When Barney Frank retired from Congress in 2013, he called the divide between the CFTC and the SEC “the single largest structural defect in our regulatory system.” Now the underfunded and understaffed CFTC is undermining implementation of the most significant financial regulation reform since the Great Depression.
It was 1998, and by all outward appearances, the U.S. economy was booming. Unemployment had reached a 50-year low, GDP growth hit the peak of a seven-year climb and stocks saw record returns. But Brooksley Born, then chair of the Commodity Futures Trading Commission, was losing sleep over a fear that it would come crashing down at any moment. Born saw the $595-trillion over-the-counter derivative market as a titanic source of risk that endangered the very foundations of the financial system. And when the economy collapsed under the weight of toxic assets years later, her “worst nightmare” came true.
Born was somewhat of an outsider in the regulatory world then. According to former CFTC director Michael Greenberger, she had earned her post as a “consolation prize” after she was passed up for U.S. Attorney General because President Clinton found her boring. Instead, she was made the head of “a sleepy, small, not terribly significant agency” that was viewed as “a small fish in an otherwise pretty big pond.”¹
At times, she felt as if she had stumbled into a regulatory twilight zone. During her first encounter with Federal Reserve Chair Alan Greenspan, the veteran economist insisted that the best way to regulate fraud — or any economic problem for that matter — was for agencies to get out of the way and let the natural forces of the free market play out. Greenspan was widely regarded as “the wizard” behind the prospering economy, and the libertarian ideas he championed were in line with the prevailing school of thought among economists and regulators at the time.¹
So when Born made the case before Congress that the CFTC should be tasked with regulating all derivatives, Greenspan, along with Treasury Secretary Bob Rubin, Deputy Secretary Larry Summers and SEC Chair Arthur Levitt, soundly rebuked her for her “dangerous” ideas and managed to get a bill passed that banned the CFTC from interfering with over-the-counter trading.¹
However, Born’s vision proved prophetic when the financial system came apart at the seams in 2008, due in part to the widespread failure of exotic derivative products. The reform efforts propelled the CFTC from the backwoods of bureaucracy to the forefront of regulatory innovation. The crisis had made the dangers of deregulation abundantly clear, and as the architects of reform set down to the task of revamping a regulatory regime that had been largely dismantled over the course of the past two decades, a key question was which agency was best equipped to reign in the overgrown OTC derivative market.
Since its inception in 1974, the CFTC had shared a vaguely spelled out and lopsided split in purview over derivatives contracts with the Securities Exchange Commission. Jurisdictional overlaps and imprecise wording had sometimes caused friction between the two organizations in the past. But when the Dodd-Frank Act was passed in 2010, it put both agencies on an even keel and encouraged duplication in rulemaking. The small CFTC, which had always stood firmly in the periphery of financial regulation, was now thrust into the thick of the action.
Given its comparatively small size and limited resources, the agency was able to accomplish a remarkable amount at the outset with Gary Gensler at the helm. Described as “a force of nature” by both friends and enemies, the former chairman is credited with indirectly orchestrating many of the derivative regulations included in Dodd-Frank and slyly maneuvering in an addendum that allowed the CFTC to regulate certain foreign markets.²
But it is now becoming increasingly clear that the CFTC is outmatched by the interests it’s facing, and the inefficiency of dueling jurisdictions over derivative trading is crippling implementation of Dodd-Frank reform in this area. The CFTC’s track record with standing up to big banks is dismal, and the agency has been smothered by an onslaught of lobbying from the finance industry.
Proposals to merge the CFTC into the much larger SEC have been introduced repeatedly in Congress, but the effort has failed to gain political traction because each agency is overseen by a separate congressional committee. The SEC draws its power from the House and Senate banking and finance committees while the CFTC is overseen by the agriculture committees. Both committees are backed by well-heeled interests like the banking industry and the farm lobby, and both have a vested interest in retaining each agency’s autonomy. Any attempt to scale back either jurisdiction would mean navigating a political mine field.
The CFTC was modeled after the SEC and meant to supplement its regulation abilities, but the two agencies have had a complicated relationship throughout the years. The demarcation gave the SEC purview over derivatives based on individual stocks, small baskets of stocks or exchange traded currency options and the CFTC covered most future contracts such as those based on commodities or indices. Many financial products exist in a hazy middle ground, however, and the SEC and the CFTC have clashed frequently over jurisdiction of more complex products.
The structure of financial regulation tends to be sprawled and disorganized in the United States because the system evolved largely as an aggregate result of reactions to various crises that have grown ensconced in politics and thus difficult to streamline.
The CFTC was founded in 1974 during the aftermath of Watergate with a mandate to regulate growing commodity future and option markets. The previous agency charged with this task, the Department of Agriculture’s Commodity Exchange Authority, was deemed unfit to keep up with the growing role that swaps were playing in the financial sector.
Its power has been expanded several times since, despite a checkered record with holding its own in the face of pressure. Critics of the agency regard it as “the redheaded stepchild of financial regulation, best known for being stepped on by more powerful political forces” and it has earned itself the nickname, “the watchdog that didn’t bark.” Most of these failures stem from the fact that the CFTC is severely underfunded and understaffed.³
As the CFTC expanded its operation to fill the need for derivative reform, it was granted little additional resources to do so. It is unreasonable to expect the CFTC to enforce regulations of a complex $400 trillion swaps market with the same budget and staff that it had while attending to the commodity futures market of only $35 trillion. The agency has only 158 employees in its enforcement division as opposed to the SEC’s 12,000.
Last year, the agency chose not to prosecute two of the traders involved in JP Morgan’s “London Whale” breach of security laws simply because it was too strapped for cash to pay legal costs. The agency was also heavily criticized by Congress when futures firm MF Global collapsed in 2012, the largest bank failure since the crisis. A congressional report judged that a lack of effective communication between the CFTC and the SEC had hindered both agencies’ ability to intervene.
This year, $10 million in budget cuts is forcing the agency to furlough employees for two-week stretches. Many of these employees already work 12-hour days just to keep up with the flood of new work brought on by Dodd-Frank. The lack of staffing is making it increasingly taxing for the agency to keep up with the 17 swap execution facilities set up to bring the shadow banking system out into the open through centralized exchanges. If the government is not able to hold the banking industry to the restrictions it sets down for transparency, it will deal a huge blow to the credibility of Dodd-Frank reform as a whole.
Any time political reform attempts to bend the will of the financial industry, the odds are overwhelmingly stacked against them. The banking industry spends hundreds of millions of dollars each year on lobbying efforts and its lobbyists will go to any length to keep regulations on derivatives from being enforced. When each major bank stands to make up to $50 billion a year dealing in derivatives, it can easily match the CFTC’s comparatively paltry budget.
The banking industry seems to be taking full advantage of the weakness of the CFTC. According to Bloomberg, it has launched “one of the largest sustained lobbying attacks on a single Washington agency.” Banking lobbyists visited the office over 2,000 times between 2011 and 2013. One of their key objectives seems to be undermining the relationship between the SEC and the CFTC.
Congressman Barney Frank had no intention to reconcile the SEC and the CFTC when he broke ground on the legislation that would later become the Dodd-Frank Act. He viewed the move as politically futile given the issues surrounding jurisdiction and thought it would unnecessarily bog down a chance at plausible groundbreaking legislation. But as he was about to retire in 2012, he made a last-ditch push to bring about a merger and introduced a bill just weeks before he left office. Frank’s decision was not fueled solely by his retirement. He claimed that Congress may be more amenable to the idea of a merger because of the rifts forming between the two agencies.
Frank said in a statement that he had come around to realize that the duplication between the two was a defining flaw in the very foundation of the legislation: “The existence of a separate SEC and CFTC is the single largest structural defect in our regulatory system. Unfortunately, this is deeply rooted in major cultural, economic and political factors in America.”
Frank may have been overly optimistic about the bill’s chances. Those who had a vested interest in preserving the agencies in their independent state were not swayed by faults in Dodd-Frank when such high stakes were on the line. In Robert Kaiser’s book Act of Congress, which chronicles the evolution of the Dodd-Frank bill, he argues that two major trends cemented the division between jurisdictions. One was the growth of derivatives and commodity futures into a multi-trillion dollar industry. In the two years leading up to the 2008 election, the House agriculture committee received $8.7 million from the financial industry and $7 million from agribusiness and the Senate agriculture committee $29.3 million from finance and $10.8 million from agribusiness. the second related trend is the drastic upsurge in the cost of congressional election campaigns that began in the late 1970s. Whereas in 1950, a Senator could pay $100,000 to retain a seat in Congress, it now costs many somewhere on the order of $20 to $30 million to run a successful campaign
The proliferation of campaign funding leads many to assume that regulatory capture is taking hold of legislation. Regulatory capture refers to the idea that a regulatory agency can be subverted from its obligation to protect public interest by a commercial interest with a stake in the regulation. Coffee (2012) and Carpenter & Moss (2014) both insist that allegations of regulatory capture are often overwrought. Coffee argues that public discontent can be used by policy entrepreneurs to balance out a large commercial interests and Carpenter & Moss say regulatory capture is often assumed when there are in fact many other interests at play. The authors maintain that the biggest risk is that industries can monopolize channels of communication.
When banking lobbyists are ready to do anything in their power to stop reformers and have the money at their disposal to do so, implementation must be airtight. The split jurisdiction was a major structural flaw that has already severely weakened the impact that Dodd-Frank could have had. Of the $300 trillion chunk of the global derivatives market that is controlled by U.S., the CFTC now only has purview over one third because of loopholes that the lobbying efforts have been able to create to exempt large swathes of the market.
¹From The Warning by Frontline (2009)
Blinder, Alan. 2013. After the Music Stopped. London: Penguin Books.
Dayen, David. 2013. “Congress Is Starving the Agency That’s Supposed to Prevent Another Meltdown.” The New Republic.http://www.newrepublic.com/article/115511/cftc-funding-will-prevent-it-regulating-derivatives (June 13, 2014).
Lynch, Sarah N. 2012. “Retiring US Lawmaker Barney Frank Seeks SEC-CFTC Merger.” Reuters.http://www.reuters.com/article/2012/11/29/sec-cftc-merger-idUSL1E8MTGFA20121129 (June 13, 2014).
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Blinder, Alan S. 2008. “Stop the World (and Avoid Reality).” The New York Times.http://www.nytimes.com/2008/01/06/business/06view.html(June 2, 2014).
“Six Doctrines in Search of a Policy Regime.” Paul Krugman Blog.http://krugman.blogs.nytimes.com/2010/04/18/six-doctrines-in-search-of-a-policy-regime/ (June 13, 2014).
“Swap Rules of Limited Reach.”BloombergView.http://www.bloomberg.com/infographics/2013-09-04/swap-rules-of-limited-reach.html (June 13, 2014).
“Toward a Global Regulatory Framework for Cross-Border OTC Derivatives Activities.” The Harvard Law School Forum on Corporate Governance and Financial Regulation.http://blogs.law.harvard.edu/corpgov/2014/03/22/toward-a-global-regulatory-framework-for-cross-border-otc-derivatives-activities/ (June 13, 2014).
“Wall Street Continues to Spend Big on Lobbying.”DealBook.http://dealbook.nytimes.com/2011/08/01/wall-street-continues-to-spend-big-on-lobbying/(June 13, 2014).