Dodd-Frank: Putting the Brakes on Free Markets

Dodd-Frank: Putting the Brakes on Free Markets

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There’s bureaucratic overstretch and then there’s a step above: the Dodd-Frank Act.

Do the math. Since the federal government began regulating commodities and futures trading 90 years ago, it enacted an average of five rules governing market trades each year. Last year, in the first five months of the Dodd-Frank financial reform legislation, the Commodity Futures Trading Commission (CFTC) created 40 new rules aimed at beefing up oversight of the commodities markets – with another 20 trading rules expected within the next few months alone.

The Dodd-Frank Act brings government meddling in the once-free and unfettered commodities markets to new heights. Traders have found it - limits increasingly challenging to comply with real-time reporting requirements that stifle the very essence of how commodities trades are made. “[Dodd Frank] is wreaking havoc among commodities traders,” says Michael Schwartz, chief marketing officer of Triple Point Technology, a firm that sells commodities management software to commodity houses and energy firms. “There’s this enormous amount of policy in place but none of its rules have been explained.”

Some of Wall Street’s largest investment banks, such as Goldman Sachs, J.P. Morgan, and Morgan Stanley, have either closed or are spinning out their proprietary trading desks that traditionally specialized in commodities trading. Prop trading, as it is known, uses the bank’s own money to make trades – the idea being that money utilized for trades, no matter how risky, is always more profitable than money sitting around doing nothing for the firm.

In the wake of uncertainty created by Dodd-Frank as to how yet-to-be created rules will affect them, few banks are willing to let their prop desks run wild. These big banks knew early on that Dodd-Frank could affect the profitability of their prop desks, and shut them down before those desks could experience the full effects of the new legislation. This apparently paid off: Many Wall Street firms reported stellar earnings last year.

If the new trading rules of Dodd-Frank have an overall theme, it’s that less money is theoretically at risk because of enhanced transparency. The problem is that money is tied up and sitting in holding accounts where a firm could otherwise invest it, says Michel Zadoroznyj, a colleague of Triple Point’s Schwartz who runs the firm’s regulatory division.

The commodities and futures markets, much like other over-the-counter markets, were traditionally known as ‘dark’ markets because it was difficult for participants to know exactly how a trader arrived at a price. Commodities traders often use swaps --a type of option, whether they use currencies, securities, or debt –to hedge against commodities prices that have the potential to fluctuate unpredictably. Dodd-Frank essentially puts the brakes on swaps and the ‘dark’ nature of the commodities markets because of its strict transparency regulations. The rules have become a nightmare for traders.

The rules discourage trades that would exploit volatile swings in the commodities markets for profit. The rise in prices (heating oil, for example, is up 36 percent year-over-year) ordinarily would provide investors and Wall Street prop desks alike with the potential for a trading bonanza.

Don’t get me wrong: That the politicians behind Dodd-Frank set out to tackle sleazy predatory lending is admirable. But the parts of the legislation that attempt to redefine the commodities markets – a classic example of Washington’s imperial overstretch – are putting traders at a disadvantage.

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