Dodd Frank is Working

Not.

Case in point, the new clearinghouses are allowing for "collateral transformation" which serves to once again misstate counter-party risk to the detriment of society and the markets:

More obviously troubling was a Bloomberg story on how major financial firms are going to undermine the effectiveness of clearinghouses by engaging in “collateral transformation”:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Understand what is happening here: clearinghouses are one of the major elements of Dodd Frank to reduce counterparty risks. But the banks are proposing to vitiate that via this “collateral transformation” which will simply create new, large volume counterparty exposures to deal with fictive clearinghouse risk reduction program. And get a load of this:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment

Translation: the regulators are aware of the banks’ plans to finesse the clearinghouse requirements, and they neither intend to put a kebosh on it (which could easily be done by taking the position that any collateral transformation to meet clearinghouse requirements was an integrated part of the clearinghouse posting and could not be done separately on bank balance sheets) nor understand the impact of their flatfootedness.

The problem is that with complexity ("Innovation") does not create benefits as much as it creates opportunities for fraud. (Saroff's rule restated)

The problem is that finance lends itself to the selling of snake oil even more than does the sale of patent medicine, and the excesses of patent medicine, most notably Radithor, led to the requirement that medications be proven safe and effective before being foisted off on the public.

We need the same policy for financial instruments.