Of all the startling revelations to come out of the financial crash, perhaps the most astonishing was this: no CEO of a major Wall Street firm seemed to understand what his own traders were doing with derivatives. As we know, just about every Wall Street firm and bank had a derivatives time bomb ticking in an off-balance-sheet closet at the heart of the building. When these bombs all blew up one after another—credit default swaps! Liquidity puts! CDOs squared!—the top executives in their corner offices were as surprised as anyone. (Click here to follow Michael Hirsh)

Wall Street can't govern itself. We know that now. So you might think that the authorities in Washington would tell the Wall Street lobby where to stick it and insist on a lot more clarity when it comes to trading in derivatives, which until now has been almost entirely unencumbered by government. That appeared to be what the Obama administration was asking for last June when it demanded that all standardized over-the-counter derivatives be traded on an open and supervised exchange, with the Securities and Exchange Commission and the Commodity Futures Trading Commission as the sole judges of what is standardized. That way authorities would know most of what was being traded and could make sure the major players weren't getting in over their heads. But thanks to weeks of intense pressure from Wall Street banks and their customers in corporate America, the bill that was approved on Thursday by Rep. Barney Frank's Financial Services Committee is riddled with exceptions and loopholes, many critics say. If it becomes law, Wall Street's finest could be driving truckloads of new derivatives products through those loopholes for years to come.

Frank disputes that. "This isn't finished yet, so it's irresponsible to talk about loopholes," says his spokesman, Steve Adamske, who notes that the House Agriculture Committee will soon address some of these concerns with its own bill. But Frank is considered the key player, and it is significant that among the toughest critics of his committee's bill is Gary Gensler, the chairman of the Commodity Futures Trading Commission. Gensler was a pro-deregulation guy in the '90s who has gotten some serious religion this time around, and he's turned out to be a far more aggressive advocate of derivatives regulation than even the Obama administration. Gensler pushed Frank's committee to drop some exemptions that would have allowed pretty much anybody to avoid trading on exchanges if they could claim vaguely that they were hedging risk. "Gensler was very helpful," says Adamske.

Gensler praised the final bill as "historic progress," but he said "substantive challenges remain." The reason? He wouldn't elaborate, but a senior regulatory official familiar with Gensler's thinking says he's worried that the broad exemption for "end-users" of derivatives in the bill—intended to excuse nonfinancial companies that use derivatives to hedge exchange-rate or interest-rate risk—is still a "big regulatory gap." It is a loophole, in other words, that may let many other players avoid regulation, including hedge funds, private-equity funds and other financial firms. ("We have tightened it up somewhat," says Adamske, adding that Frank is requiring "reporting" of all trades.) Gensler is also concerned that all foreign-exchange trades as well as dealings on overseas exchanges will be exempted—it was dealings in forex trading, for example, that sank Long Term Capital Management in 1998—and that the CFTC will not have enough authority over exchanges and clearinghouses, for example, to set margin requirements. And he's worried about a provision that allows privately run clearinghouses dominated by Wall Street to change rules or contracts without CFTC review, undermining the authority of government regulators.

Corporate customers of Wall Street have been, in large part, pushing for such exemptions. But they should think hard about this. Yes, they want to avoid the margin requirements for derivatives that mean they have to put up capital on an exchange. But one of the reasons Wall Street is back to making record profits—and awarding itself record bonuses—is because of all the proprietary trading it does in derivatives and structured products off exchange. Huge profits are why the banking industry resisted all efforts in the '90s to "standardize" derivatives and allow them to be traded on an exchange. For the banks, the more custom-made and out of sight the derivative, the harder it is for investors to figure out its fair value and real risk—and the easier for the banks to charge a large "spread" and make a profit. Guess who was coming out on the bad end of those deals? Their customers.

The failure to push standardized derivatives onto exchanges was also why the ratings agencies got away with such bad and fraudulent ratings of subprime-mortgage-backed securities products: there was no way to check what they were doing. "The spreads in exchange trading are a tiny fraction of what they are customized products," says Barbara Roper of the Consumer Federation of America. "The requirement for exchange trading has the potential to really lower costs." Gensler agrees.

The reason is simple capitalism. Open, competitive markets mean lower prices. Rigged markets—what we have now—means someone makes out like a bandit. That someone continues to be Wall Street, which came very close to blowing itself and the rest of us up late last year and is now settling back into its old comfy profit margins. And that, at least, should be fairly easy to understand.

Michael Hirsh is also the author of At War with Ourselves: Why America Is Squandering Its Chance to Build a Better World.

© 2009