One reform to financial market regulation that has been widely (though not universally) endorsed is putting credit derivatives onto organized clearing exchanges. It is, for example, an important part of the Treasury White Paper on financial regulation reform. The WSJ ran a story yesterday, “Derivatives Plan Is Expected” (Thursday, July 30, 2009, C7) on where the plan currently stands with regulators and Congress.
The derivatives proposals coming to Congress (one of these days) are mixed up among several issues (note: a useful site to keep track of government regulatory efforts is the Treasury site FinancialStability.gov):
One, how to regulate derivatives – what kinds and in what ways, and should certain instruments be banned or, if permitted, require different capital and leverage and margin rules. The WSJ article focuses entirely on credit default swaps (CDS). I don’t disagree with the issues raised about CDSs, but think that the problems created by derivatives are as much or more on the leveraging of securitizations – in other words, the CDOs and similar instruments ratcheting up the leverage on securitizations, rather than CDS. The answer to CDOs and similar instruments might be less regulation of the instruments than simply limits on leverage, however arbitrary and clumsy that might be – sometimes second best solutions are better than the alternatives.
With respect to CDSs, the regulatory proposal is currently, first, to create standardized contracts that are traded and cleared on centralized exchanges, thus addressing the considerable problem of undisclosed counterparty risk as well as facilitating valuation via standardized contracts and presumably creating standards for margin and leverage. If parties wanted to go with customized, non-standard, off-exchange contracts, they would be subject to capital and margin requirements on these contracts (and perhaps disclosure to regulators of counterparties, so that someone would presumably be aware of the possible counterparty risks). These seem to me sensible regulatory changes.
More controversial is whether so-called “naked” CDSs should be banned. These are CDSs entered into by parties not for purposes of identified hedging – in other words, not using CDSs for one’s own risk-hedging as insurance. This seems quite off to me – the “speculators,” if one wants to call them that, provide liquidity and an important specialized information function. The Journal article remarks that there is concern among regulators that naked CDSs were being used to manipulate markets, but I am unsure as to what precise phenomenon the article means. I assume this is a reference to the “empty creditor” problem, but in that case the regulatory proposals, whether to ban them altogether or ban non-hedgers or non-market-makers, don’t make very much sense to me, unless I am missing something major.
The problem of “empty creditor” is that a “creditor” of an enterprise has nothing at risk, having offloaded it by purchasing a CDS as insurance, and so is actually rooting for bankruptcy so that it can trigger its CDSs and do better than as a mere creditor. Banning naked CDSs or prohibiting non-hedgers or non-dealers from purchasing CDSs does not appear to me the best solution, if that’s the problem they mean, and seems to create market distortion, not clarity in pricing. The problem is created, first, by the discontinuity of bankruptcy; I would have thought the better answer re-writing the bankruptcy provisions to apply only to creditors with something actually at stake, rather than those who have hedged it away. And, second, by mispricing by writers of CDSs as insurance, such as AIG – they allowed purchasers of CDSs to take out insurance and shift risk for an inadequate premium. If empty creditors are the problem, I don’t agree with either a ban or a bar on “non-bona fide” hedgers or market-makers ….
Here is the Journal account of this CDS debate:
According to a draft copy of the joint agreement [reached by House Democrats Barney Frank and Collin Peterson] seen by The Wall Street Journal, it calls for standard contracts to be cleared and traded on exchanges, and proposes increasing capital and margin requirements for custom contracts. It also proposes two different approaches aimed at reining in speculation, including a controversial ban on a certain type of contract.
The guts of the lawmakers’ outline are largely in line with what the administration wants, but their plan leaves open the possibility that so-called naked credit-default swaps — those that aren’t used to hedge against an underlying credit risk — could be banned. Under their plan, credit-default swaps would be allowed when used to hedge against risk or done by bona fide market makers.
Wall Street dealers and hedge funds that use credit-default swaps to make bets on the fortunes of companies and homeowners are mostly opposed to regulation that would prohibit certain trading strategies. They say trading curbs would be difficult to enforce in practice, and could create more loopholes — for example, an investor who holds a bond and buys a swap could turn around and sell the bond quickly.
“The notion that trading should be prohibited is bizarre — I don’t think it’s commercially workable and it could have very negative effects on the market,” said Robert Claassen, a derivatives lawyer at Paul, Hastings, Janofsky & Walker LLP.
A Treasury spokesman said the administration “is in complete agreement with the leaders on the Hill that the [over-the-counter] derivatives markets need more transparency, more centralized clearing and trading, stronger prudential regulation of dealers and major market participants, and better investor protections.” However, Treasury Secretary Timothy Geithner has said he didn’t think a ban on naked swaps was necessary. ….
As an alternative to a ban, the lawmakers are proposing to increase oversight of naked swaps by requiring dealers, larger investors and “major market participants” to disclose to regulators information about their positions. Regulators would be given authority to impose position limits and ban any nondealer from buying a naked credit-default swap.
The lawmakers’ are seeking to address concerns that excess speculation of derivatives, especially credit default swaps, were used to bet on the failure of certain companies or to manipulate underlying securities, exacerbating the financial crisis.
Bankers said artificial constraints on swap trading could have unintended effects and lead to price distortions in the financial markets. They also note that most of the institutions that ran into trouble in the credit-default swap market last year were big sellers of protection, not buyers.
Two, what regulatory agency or agencies should have regulatory authority and how, if multiple agencies, should responsibilities be divided. It is a turf war between the SEC and the Commodities Futures Trading Commission (CFTC). This kind of interagency fighting seems to outsiders like me to be frustratingly parochial – a mere battle among agency players for power, turf, jurisdiction, etc. On the other hand, there are legitimate questions about what agency is best equipped to address certain kinds of securities and financial instruments.
These are hard questions for outsiders to answer, because they go fundamentally to effectiveness, resistance to client capture, expertise and competence. It goes to execution rather than planning. Richard Posner’s new book on the financial crisis, A Failure of Capitalism, makes a point made by a new literature in management theory, arguing that the problems are largely not matters of design, but execution. (In this, Judge Posner is drawing on his research into 9-11 and the difficulties of coordinated bureaucratic response where, once again, he finds that the problems of execution outweigh problems of design; not that design of the system is not important, but designs are not self-executing.) I do not have a view on this turf war, but would be interested in informed comments on it.
Three, how do US regulatory efforts, and more broadly the move to put derivatives on clearing exchanges, interact with moves to do the same elsewhere in the world, particularly Europe? Another WSJ article, also Thursday, July 30, 2009, “ICE Starts Clearinghouse for Derivatives,” notes that Intercontinental Exchange (Atlanta-based) has started clearing contracts for European positions as well as US contracts:
ICE, which officially launched its European credit-default-swap clearing service Wednesday, is among a handful of exchanges competing to handle credit-derivative transactions in Europe, nearly four years after the industry’s first attempt to enter the market. The financial crisis is the driving factor now. Authorities on both sides of the Atlantic see clearinghouses, which serve as central counterparties between buyers and sellers, as a way to reduce risk in over-the-counter instruments.
But ICE’s platform carries the support of 10 major dealer banks that have made the Atlanta-based exchange operator the de facto leader in the U.S. …. Dealer banks have moved proactively to clear credit-derivatives trades, staying ahead of U.S. authorities’ push to mandate clearinghouses for the complex financial instruments.
The article notes that a big question is how many exchanges the derivatives trade can support, as rival platforms are launched in various places and aimed at various markets.