Derivatives on Exchanges:

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 ….

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