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Regulating Derivatives Traffic

Establishing Speed Limits and Traffic Lights to Improve Derivatives Safety

SOURCE: AP/Danny Johnston

Sen. Blanche Lincoln (D-AK) speaks at a candidate forum held by the Arkansas Farm Bureau in North Little Rock, Arkansas. Sen. Lincoln introduced a comprehensive derivatives bill late last week that is much tougher on Wall Street than originally expected.

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The Senate returned to work last week with financial reform at the top of its agenda, and Sen. Chris Dodd’s (D-CT) regulatory reform bill is expected to proceed to a floor vote in the next several weeks. A critical part of the reform effort is regulation of financial derivatives—famously called “financial weapons of mass destruction” by investing icon Warren Buffett and a key contributing cause of the 2008 financial panic.

Sen. Blanche Lincoln (D-AR), who chairs the Senate Agriculture Committee, which shares jurisdiction over derivatives regulation with Sen. Dodd’s Senate Banking Committee, introduced a comprehensive derivatives bill late last week that is much tougher on Wall Street than originally expected. Sen. Lincoln’s bill will be marked up in committee this week, and many observers believe that the resulting derivatives legislation will be merged with Sen. Dodd’s bill. Big Wall Street firms are furiously rallying their lobbyists in opposition to her proposal, and the future of derivatives regulation is uncertain with many conservatives already expected to oppose the overall bill.

It is critical that Congress implement a robust regulation of derivatives. Exposure to unregulated “over-the-counter” derivatives was at the heart of the 2008 financial crisis. Lehman Brothers Inc. and insurance giant American International Group’s inability to honor their many billions of dollars in credit default swap derivative obligations caused investors to question the value of the many financial instruments tied to credit default swaps, causing a classic run on the bank situation for the unregulated parts of the financial system. It was this run on the so-called “shadow banking system”—which performs the functions of banking but outside the regulatory safeguards in place for banks—that led to the bailout of AIG and the large new menu of Federal Reserve programs designed to prevent further disruptions.

The problems with derivatives can be summed thusly: There is too much traffic, it’s high risk, and it’s moving in the dark of night. These are all conditions for a massive pileup. We need speed limits, traffic cameras, and street lights, and we can get these by routing as much of the trading as possible through central clearinghouses and/or market exchanges like those used for futures and options contracts and stocks. This would reduce risk, improve transparency, and make it easier for regulators to track any areas where systemic risk is building. We will remain highly exposed to the risk of another financial meltdown until this happens.

Credit default swaps and their role in the financial markets

Derivatives are a broad class of financial instruments whose value depends on, or is derived from, underlying financial instruments, events, or conditions. A derivative is a contract between two parties where the value of the contract is linked to the price of another financial instrument or a specified event or condition. For example, an airline might purchase a derivative that would pay out in the event of a spike in jet fuel prices as a way to keep its future costs more certain. As the Financial Policy Forum describes, derivatives are meant to “capture, in the form of price changes, some underlying price change or event.”

Derivatives come in many forms, including the “credit default swaps” that became so notorious during the financial crisis. One of their primary purposes is to allow end users—both financial and nonfinancial actors—to hedge against various risks, including the risk that interest rates might rise or the risk that a foreign currency might suffer devaluation. The risk in the case of credit default swaps is that of a credit default—that the underlying bond will not make its promised payments due to credit losses. The buyer makes regular payments, and in return the seller promises to step in and make up the difference should the underlying bond or security fail to make its full payments. As many commentators have noted, credit default swaps look a lot like insurance on bonds and other securities.

One major difference between credit default swaps and insurance, however, is that a CDS buyer does not need to own the underlying bond or have any direct interest in it. The CDS are therefore frequently used as a vehicle for speculation, allowing investors to “gamble” on certain market outcomes. As the Center for Economic and Policy Research’s Economist and Co-Director Dean Baker has noted, investors heavily utilized credit default swaps as a way to bet against the subprime mortgage market. In fact, this type of speculation is at the heart of the fraud that the Securities and Exchange Commission has alleged against Goldman Sachs. The hedge fund that Goldman Sachs allegedly allowed to structure a debt offering in exchange for payments was using the CDS to effectively bet against that same offering.

Speculators’ use of derivatives has grown tremendously in recent years. Derivatives currently constitute an astronomical $300 trillion in notional value—although as Brookings Senior Fellow Robert Litan notes, the amounts actually at risk are much lower. And there were $78 of outstanding derivatives exposure for every $1 used by a company to legitimately hedge against risk in 2009.

Regulators currently have no direct jurisdiction over credit default swaps, which means they lack visibility into whether and where they might pose excessive systemic risk, and have no authority to do anything about those that pose any systemic risk. Credit default swaps and other swaps, such as interest-rate swaps, are exempt from direct regulation due to the Commodity Futures Modernization Act of 2000, which then-Sen. Phil Gramm (R-TX) managed to pass by attaching it to an unrelated budget bill. They are also traded “over the counter,” which further adds to their opacity because they are not traded on exchanges but are instead traded in private transactions between financial institutions.

Because there is no open marketplace for the CDS and other swaps, those seeking to buy or sell them for hedging or speculative purposes typically contract with one of the large Wall Street dealers such as Goldman Sachs or Morgan Stanley for their derivatives demands. The dealer essentially acts as a market maker for these swaps; it finds a counterparty when it can—sometimes through another of its clients who is seeking the converse position, sometimes through another big dealer whose client is seeking the converse position—and assumes the risk itself otherwise. The market for over-the-counter derivatives is highly concentrated in part because of this structure. The five largest derivatives desks—JP Morgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc., and Wells Fargo—account for 97 percent of the activity.

The 2008 financial crisis exposed some critical flaws in the structure of the over-the-counter derivatives market. First, it was apparent that a key aspect of the “too big to fail” problem—which is really a problem of banking panics—was the high degree of interconnectedness between large financial institutions, and this was being driven in large part by the $45 trillion CDS market. Derivatives such as credit default swaps inextricably tie the big financial firms together. Lehman Brothers and AIG’s failures were so traumatic for the financial markets because investors were concerned about the high degree of exposure of other firms to these two entities, which would not be able to fully pay their derivatives obligations.

The crisis at the same time revealed that there were insufficient safeguards to ensure that banks would actually be able to pay their credit default swap obligations. The big derivatives dealers set their own rules as far as ensuring the derivatives’ safety because the swaps were unregulated and concentrated. They typically required their smaller customers to post collateral against the risks they were taking on: CDS buyers posted collateral to ensure that they would continue to make payments, and CDS sellers posted collateral to ensure that they would be able to make good on their obligations should the underlying bond default. But when it came to bigger counterparties, such as AIG or the other dealers, the collateral rules were much laxer. As Lehman Brothers and AIG made clear, this failure to require sufficient collateral was an enormous problem.

The opacity of the CDS market also means that no one—regulators, investors, or even the dealers themselves—has a good handle on the systemic risk these instruments pose, or who is bearing the risk. This prevents regulators from being able to take steps to reduce systemic risk and creates the conditions for financial panics. Part of the reason the markets reacted so strongly to Lehman Brothers and AIG’s failures was that there was no clear idea of how much exposure or where there was to those derivatives. For example, an investor in bonds issued by Morgan Stanley had no way of knowing how much Morgan Stanley might lose from its exposure to Lehman Brothers and AIG, and whether this might be significant enough to harm Morgan Stanley’s ability to make good on its own bonds.

These problems aren’t just historical antecedents, either. Over-the-counter derivatives markets are still highly vulnerable even after the stark lessons taught by the 2008 financial crisis. The International Monetary Fund last week estimated that the five largest U.S. derivatives dealers are currently undercollateralized by between $275 billion and $500 billion on their derivatives exposure. In other words, the financial markets are ripe for another crisis triggered by the inability of derivatives dealers to make good on their derivatives obligations.

So what are the proposed solutions to the problems with the status quo, and how would they work? There are three main approaches out there. The first proposal, put forth by the Treasury Department last year, focuses on routing over-the-counter derivatives trades through a central clearinghouse. The second proposal, offered last Friday by Chair of the Senate Agriculture Committee Sen. Lincoln, would require banks to trade most over-the-counter derivatives on an exchange and force the major Wall Street firms to spin off their derivatives trading desks into separate entities. The third approach to derivatives reform has been for conservatives to defend the status quo and blame the financial crisis on overregulation.

The Treasury Department’s proposal

The Obama administration’s approach to derivatives leans heavily on the use of centralized clearing, which is meant to improve safeguards against derivatives risk and provide regulators with an enhanced view of the systemic risk posed by derivatives.

As Litan describes, clearinghouses “step into the middle of derivatives trades, becoming the buyer to every seller, and the seller to every buyer. By ending the bilateral relationships between the two counterparties to derivatives contracts, clearinghouses reduce the risk that the failure of any one party could trigger domino-effect losses on other counterparties.”

Centralized derivatives clearing would serve two key functions. First, it would require firms to post variable collateral based on net derivatives exposure. This would effectively raise derivatives dealers’ capital requirements, mitigating against the possibility of another Lehman-type situation where a major derivatives dealer lacks the funds to pay off its derivatives obligations. Second, centralizing all derivatives trades would provide visibility to regulators of where systemic risk is building—which firms have excessive risk, and in what areas of exposure. This is a key part of the systemic risk regulation regime that the Obama administration is proposing. A systemic risk regulator must have visibility into the derivatives market in order to do its job effectively.

Sen. Blanche Lincoln’s proposal

Sen. Lincoln unveiled her derivatives reform bill last week, which surprised many observers by proposing to aggressively regulate derivatives. There are two key aspects to this proposal: forcing most derivatives trades onto exchanges, and effectively requiring Wall Street financial institutions to divest themselves of their derivatives trading. Sen. Lincoln’s bill would also require all exchange trades to be centrally cleared, so it would have all of the benefits of Treasury’s centralized clearinghouse approach.

An exchange is essentially an open marketplace where buyers and sellers can meet. One of the key features of an exchange is that its transactions are public. This increased transparency provides regulators with a more dynamic, higher-quality view of systemic risk than a clearinghouse. And by providing this information to investors, an exchange introduces market discipline into derivatives trading. As Commodity Futures Trading Commission Chairman Gary Gensler put it, “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk…Such centralized trading venues not only bring greater transparency, but also increase competition in the markets.”

Furthermore, as Sen. Lincoln herself notes, her bill would end the opacity that allegedly allowed Goldman Sachs to perpetuate self-dealing in one of its securities offerings.

Sen. Lincoln’s bill would also effectively require financial institutions to spin off their derivatives trading activities into separate subsidiaries. The bill would remove any federal assistance, including FDIC depository insurance or access to Federal Reserve liquidity, from any institutions that trade derivatives. Wall Street firms critically depend upon these forms of government assistance, and they would be forced to separate their derivatives trading desks into independent units. The point of this provision is to separate risky derivatives activities from the core banking functions of financial institutions.

One important question Sen Lincoln’s bill faces is whether and to what extent there should be exceptions to the exchange trading requirements for derivatives. Exchanges require standardized products to be effective because they work through matching large numbers of buyers and sellers. As some opponents of reform have noted, many legitimate derivatives purchasers seeking to hedge their risk are looking for very specific, nonfungible derivatives that must be specifically customized to their needs.

Sen Lincoln’s bill addresses this concern by exempting from its exchange all nonfinancial “end users” who are seeking to enter into a derivatives transaction for hedging purposes. In fact, these users would probably benefit from the Lincoln proposal insofar as its exchange-traded derivatives provide pricing benchmarks for comparable types of derivatives.

One of the key ways in which Wall Street is likely to try to water down the Lincoln proposal is by seeking to broaden this end user exemption. It is worth keeping in mind, however, that the problems created by the derivatives market were caused in no small part by the CFMA’s original regulatory exemption for swaps, which were a very minor market at the time. The broader the exemptions, the more likely it is that we will find ourselves dealing with another financial crisis in the near future.

Defending the status quo

Free-market conservatives such as Rep. Scott Garrett (R-NJ), a high-ranking member of the House Financial Services Committee, have found themselves in alignment with Wall Street in opposing any significant reforms of the derivatives market.

The basis for this opposition is ideological and rooted in a willful ignorance of what happened. As Rep. Garrett has argued, “derivatives played a limited role in the current financial crisis, and the knee-jerk reaction to [regulate] threatens to create serious harm not only to financial markets but more importantly to thousands of non-financial companies that America needs to create economic growth…Over-regulation or improper regulation of derivatives markets would represent a misguided response to problems that came out of other parts of our financial system.”

But defense of the status quo is purely about the money for Wall Street. The inefficient structure of the opaque and decentralized derivatives market has allowed the big derivatives dealers to reap enormous, above-market returns from these operations. The increased transparency of exchange trading would significantly shrink these profits, as would the forced separation of their derivatives desks. In a conference call with analysts, JP Morgan Chase chief executive officer Jamie Dimon estimated that derivatives regulation could cost his company “from $700 million to a couple billion dollars.”

Many speculators are also strongly opposed to these reforms, as the opacity of the current market allows them to make disguised bets. The activities alleged last week by the SEC—namely that Goldman Sachs, in exchange for $15 million, allowed the hedge fund Paulson & Co. to structure a debt offering that it was itself shorting—would have been much more difficult to perform in a transparent marketplace.

These defenders of the status quo have their own reasons for opposing the well-reasoned reforms proposed by the Treasury Department and Sen. Lincoln, but the rest of us who have to pay the costs when the financial markets crumble, should be pushing to have these reforms adopted as quickly as possible.

David Min is Associate Director for Financial Markets Policy at the Center for American Progress. Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.

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