Posted by Kenneth Anderson:
Derivatives on Exchanges:
http://volokh.com/archives/archive_2009_07_26-2009_08_01.shtml#1249058143
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
[1]Treasury White Paper on financial regulation reform. The WSJ ran a
story yesterday, [2]"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
[3]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 [4]"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 ....
([5]show)
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, [6]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 [7]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, [8]"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.
([9]hide)
References
1. http://www.financialstability.gov/roadtostability/regulatoryreform.html
2.
http://online.wsj.com/article/SB124891172576091953.html#mod=todays_us_money_and_investing
3. http://www.financialstability.gov/roadtostability/regulatoryreform.html
4. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1084075
5. file://localhost/var/www/powerblogs/volokh/posts/1249058143.html
6.
http://www.amazon.com/Failure-Capitalism-Crisis-Descent-Depression/dp/0674035143/ref=sr_1_1?ie=UTF8&s=books&qid=1249053533&sr=1-1
7.
http://www.amazon.com/Countering-Terrorism-Blurred-Politics-Economics/dp/0742558835/ref=sr_1_1?ie=UTF8&s=books&qid=1249053589&sr=1-1
8.
http://online.wsj.com/article/SB124889216246790945.html#mod=todays_us_money_and_investing
9. file://localhost/var/www/powerblogs/volokh/posts/1249058143.html
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