Reform of US OTC derivatives is gathering momentum in Congress, amid a storm of hot air. Philip McBride Johnson has some advice for legislators on achieving a sane solution.
The Obama administration’s proposal for
reforming over-the-counter derivatives is a little sheepish
about defining the roles of the Securities and Exchange
Commission and the Commodity Futures Trading Commission.
But otherwise, it is fairly clear in advocating a model
familiar to those of us in the futures markets: open and
competitive trading through regulated exchanges, with credit
support by central clearing counterparties.
Implicitly, the Obama team is acknowledging that the Best
and Brightest can fail when left to their own devices, but with
one difference – they fail far more spectacularly than
you and I would.
Meanwhile, bills emerge in Congress almost daily with some
of the administration’s ideas but a few tweaks of
their own. It would be the apex of recklessness to predict the
final result, but here are some of the key issues.
Mandating exchange trading
It is proposed that OTC derivatives should be forced on to
regulated exchanges or trading platforms.
This concept works best (some would say only) when the
instruments are as fungible as possible. When it is time to
liquidate a position, the ability to buy back the same thing is
critical. And yet, many swap participants resist
standardisation, claiming that they can address their business
risks only with customised instruments. True, but, in my
Until the Looney Law (sorry, the Commodity Futures
Modernization Act of 2000), nearly all hedging instruments were
standardised. Farmers, miners, oil barons and other users made
do with fungible futures and options contracts. Maybe the fit
was imperfect by a margin of 5% or so, but the vast bulk of
risk could be neutralised in this manner.
So, my first suggestion to Congress is that someone
– the regulator or the person requesting exemption
from having to use an exchange – should quantify how
much of a risk can be addressed with standardised derivatives.
OTC transactions would be authorised only for the rest.
And yet, many competent and honourable people insist that
customisation is critical for efficient hedging. Hear them out.
We are trying to encourage risk management, not undermine
Another objection to exchange-based trading is the
transparency that results. While we may not learn the identity
of the players, we can see deals made and watch the size and
shape of the market as it sways and shifts. The secrecy so
cherished in the OTC world, which allowed us to be so
thoroughly blindsided by the financial meltdown, must largely
be sacrificed under an exchange-based regime.
As I have noted before ('Good regulation is the art of
knowing,’ FOW, July 2009), what we know may
worry us but what we don’t know can kill us.
So, regardless of how the exchange issue is resolved, I
recommend that OTC trade data should be fully and prominently
Futures-style credit support
Many of the financial reforms under consideration include
credit safeguards used in regulated futures. Transactors must
post margin, and add more if losses begin to accumulate.
Brokers must guarantee their counterparties against loss if the
customer defaults and, for this reason, must maintain a certain
level of capital. Often, an interposing clearing
member’s capital stands behind that default as
well. And, lastly, the multi-billion dollar clearing house
provides the ultimate safety net.
Some OTC participants complain that this would burden them
with cashflow problems. They prefer instead to negotiate credit
terms with each counterparty, freeing up capital for other
I suggest that Congress compare the nation’s
recent experience with these two approaches. The regulated
futures markets have required no bailout funds, while the other
scheme has cost taxpayers hundreds of billions of dollars. Of
course the futures way is more expensive – that is
what makes it work.
Even so, time and attention needs to be paid to this
cashflow burden. Congress and the relevant agencies should
fully understand what effects a futures-style margining system
could have, including the risk that participants might not
hedge, or might do so in a friendlier foreign jurisdiction.
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