Monday, August 31, 2009

Derivatives Regulation: Financial Innovation versus Systemic Stability

Posted on Fin Reg21 by Emilios Avgouleas:

Derivatives trading has been a very useful and integral part of our financial system and should remain so in the future. However, the derivatives industry has not fallen on hard times for no good reason. It is difficult not to agree with the conclusion of influential regulatory and international policy body reports that much of financial innovation of the past decade was pure social waste (UNCTAD 2009, UN Commission of Experts 2009). Furthermore, the use of derivatives fostered by the development of the shadow banking sector eventually became a menacing threat to global systemic stability; for example, American International Group’s (AIG) gigantic credit default swaps (CDSs) portfolio literally threatened the global financial system with collapse. In many ways the use of the highly opaque CDSs amounted to no more than wild bets on the continuation of the housing boom in the U.S. and other western countries, perennial economic growth, and low interest rates.

However, misuse of financial innovation was in many ways more the result of disastrous government policies, incomprehensive capital adequacy regulations (Brunnermeier et al. 2009, Hellwig 2008), and global macroeconomic conditions, and less the by-product of the industry’s customary pre-occupation with short-termism and mega-profits. This essay attempts to highlight the underlying causes that led derivatives trading to become a source of systemic instability. It argues that, if these causes are properly identified, then the international regulatory and investment communities can move away from both the pack of naysayers within their ranks and the crowd of witch hunters, setting instead for themselves the sober task of devising regulatory reforms that would make financial innovation less threatening to systemic stability and more welfare enhancing.

The Global Financial Crisis and Derivatives Markets
The excessive use by financial (mostly banking) institutions of maturity transformation (Hellwig 2008, FSA 2009) mainly through the use of the originate to distribute model to fund their asset book, the use of credit derivatives to, inter alia, replicate the risk distribution effects of securitization (so-called synthetic securitizations), and the explosion of shadow banking vehicles meant that inadequately managed and monitored credit risk was massively sold and transferred to global capital market investors (Lo 2009). Capital market investors were ill-equipped to properly manage this amount of credit risk both because of lack of information and relative lack of quantitative skills. However, actions that preceded the above developments set the groundwork for the disastrous proliferation of the use of derivatives in those contexts. These actions were the deregulatory laws of the 1990s, the flawed monetary policies of this decade, and global macro-economic conditions.

Legislation that led to the deregulation of the financial services industry in the 1990s placed no limits on the use of highly speculative instruments even as it increased industry homogenization and strategic trade behavior (herding) in global markets; eventually all banks’ balance sheets looked more or less the same and so did their risk management and trading policies (Haldane 2009). In the absence of regulatory restrictions, shadow banking operations proliferated. As a result, even venerable institutions like AIG eventually adopted trade and investment policies that more resembled those of highly geared/highly speculative and unregulated hedge funds (Lo 2009), rather than the conservative investment policies normally associated with insurance firms.

Furthermore, low interest rate policies in the U.S., the U.K., and the rest of the EU not only led to the formation of gigantic asset bubbles, especially in the housing sector, but also fuelled irrational exuberance sentiments in the markets (Avgouleas 2009). Market participants acting on the belief that the good times would last forever started making investment decisions that involved the acquisition of disproportionately risky assets through the obvious channel of derivatives trading. Arguably, those decisions were much more the result of “animal spirits” and much less that of any rational risk calculation (Shiller and Akerlof 2009, FSA 2009).

At the same time, international trade liberalization and a bubble in global oil and commodity prices led to the accumulation of gigantic trade surpluses in developing countries which could not be invested in underdeveloped domestic financial systems (UN Experts Report 2009). Thus, they sought higher yields abroad and inevitably ended up, in part, as investments in derivatives markets either directly or indirectly through investment participations in hedge funds or shadow banking vehicles.

Finally, flawed regulations that fostered ratings arbitrage through the use of derivatives and wrongfully focused on capital adequacy without placing any restrictions on leverage increased the fragility of the system as a whole because of interconnectedness. For instance, Lehman Brothers’ CDS exposure was eight times bigger than its capital (Haldane 2009).

The biggest consequence of the proliferation of OTC derivatives trading in the past decade and especially of the use of credit derivatives was that it increased complexity while at the same time bringing – in very opaque ways – the different parts of the financial system closer together, thus strengthening ties of interconnectedness. According to the EU Commission, “the characteristics of OTC derivative markets – the private nature of contracting with limited public information, the complex web of mutual dependence, the difficulties of understanding the nature and level of risks – increases uncertainty in times of market stress and accordingly poses risks to financial stability” (EU Commission Communication 2009). Furthermore, risks from the use of CDSs was exacerbated by the fact that financial institutions are normally lenders and borrowers at the same time, a situation that prevented the taking of offsetting action to limit exposure “because of concerns about counterparty credit risk” (Brunnermeier 2008).

However, the systemic risks created by derivatives trading are not a “black swan,” i.e., an extremely rare and thus virtually unpredictable event (Taleb 2007). In fact, they have materialized with worrying regularity since derivatives trading became a mainstream market activity (for example, the troubles of Long Term Capital Management in 1998 and the systemic risks posed by its inability to unwind its derivatives positions). On the other hand, margin requirements tend to be insufficient to stem systemic instability. Margin calls will only necessitate further asset sales and thus further depreciation of traded assets’ value (Brunnermeier 2008), assuming that a liquid market exists with willing buyers of such assets.

None of the above findings exonerates the derivatives industry from its obvious responsibility for deliberately creating highly complex financial instruments whose value could not be calculated. Yet the increased interconnectedness created by complex derivatives such as credit default swaps was more the by-product of mindless conglomeration and resulting balance sheet homogenization that reduced the resilience of the financial system and increased interconnectedness and less because of the use of the specific instruments per se. Regulators and senior bank management did not heed the threats to systemic stability involved in the use of derivatives to lay off credit risk. And, while short-termism and limited understanding is responsible for the attitude of the latter, the former proved to be victims of their quasi-religious belief in the correcting powers of the invisible hand. How this would make systemic risk disappear remains a mystery. Equally puzzling is regulators’ lack of alertness to the risks posed by increasing interconnectedness created by derivatives trading. Given the total lack of transparency characterizing credit derivatives markets and the absence of a global register of claims against financial institutions, regulators should have been put at the highest state of alarm long before the second phase of the global financial crisis in September 2008, when these became evident even to lay observers.

Proposed Remedies
The central point of the preceding analysis was that the flawed use of complex derivatives was a by-product of other developments, such as unrestrained financial liberalization and conglomeration, and of global macro-economic conditions. Also, excessive maturity transformation and risk arbitrage was partly the industry’s fault (motivated by greed and focused on short-term profit) and partly the result of flawed and incomprehensive capital adequacy regulations. Assuming that the above reflect a broader consensus, it becomes much easier to devise appropriate reforms to protect systemic stability for financial innovation without unduly stifling the industry’s creativity. Arguably, three reforms of varying intensity would suffice to resolve the financial innovation versus systemic stability dilemma.

The first reform relates to the regulators’ establishment of central counterparty facilities for the clearing and settlement of OTC derivatives transactions (establishment much prized by the EU and U.S. regulators) (EU Commission Communication 2009, U.S. Treasury 2009a, b). Centralized clearing for OTC derivatives trading would enhance the transparency of these markets and greatly increase the resilience of the global financial system/network (Haldane 2009, EU Commission 2009, U.S. Treasury 2009a).

The second remedy would be to reconsider network robustness and especially the impact of conglomeration, namely to consider whether a change to the structure of the financial network is feasible, beneficial, and desirable (Haldane 2009). As a first step, regulators could place limits to what kind of exposures mainstream savings and loans institutions could have to derivatives markets or to institutions whose main source of revenue is derived from speculation in derivatives markets, such as hedge funds. This approach would incrementally lead to deconglomeration. This would also be the direct outcome of the G20 resolution to bring the shadow banking activities of regulated institutions under regulatory oversight. Also, this complex and expensive exercise is, in fact, no more arbitrary than assigning risk ratios to trading book assets for capital adequacy purposes and it would benefit the financial services industry and its customers in more than one way. First, it would enhance competition, as banking markets would inevitably become more contestable and less oligopolistic in the absence of today’s mega-banks. Second, it would safeguard systemic stability through the forced decoupling/dehomogenization of big banks’ balance sheets, increasing the system’s resilience. It is, thus, unfortunate that only Mervyn King, the governor of the Bank of England, seems to seriously discuss the benefits of deconglomeration in the financial services industry. [1]

The third remedy should be to require the relevant committees of the International Swaps and Derivatives Association (ISDA) to devise special rules for the orderly winding up of outstanding derivatives exposures in times of financial distress. These would reduce the amount of open positions and thus systemic risk stemming from the possibility of multiple institutional defaults (Hellwig 2008).

International Public Interest Oversight of ISDA Rulemaking Functions?
The urgent need for ISDA to devise special close-out netting and set-off rules, which would have to override national property and insolvency laws, for the winding up of outstanding derivatives positions in the event of institutional default or financial distress, means that ISDA’s rule-making function must be brought under some form of international public interest oversight. Already most rules promulgated by ISDA, although of a private law nature, almost always become de facto and very often de jure (as they are followed by implementing national legislation) binding in most major market jurisdictions. Thus, bringing ISDA’s rule-making function under some kind of global public interest oversight should be seen as a desirable inevitability.

This has already happened in the case of the International Accounting Standards Board (IASB) which promulgates International Financial Reporting Standards (formerly International Accounting Standards). In the aftermath of the Enron crisis, the standard setting committees of the International Federation of Accountants, including the IASB, came under the oversight of the Public Interest Oversight Board whose ten members are nominated by the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, the World Bank, and the European Commission.

Arguably, instead of establishing yet another bureaucracy, international public oversight of ISDA’s rule-making function could be provided by the new Financial Stability Board (FSB) (formerly the Financial Stability Forum), although such a move would go much further than what was agreed in April’s G20 summit as to the remit of the revamped FSB. This solution would also mean that the body with the greatest involvement in maintaining global financial stability would have direct involvement, information, and knowledge about new financial instruments allowing it to assess the ramifications of their use in terms of systemic stability. Moreover, given that the FSB is supposed to be less subservient to the interests of domestic financial services industries than many of the mighty national regulators comprising its membership, FSB’s involvement could ensure a certain level of impartiality and avoidance of regulatory capture.

Concluding Remarks
Giving serious consideration to the concurrent implementation of all of the three remedies suggested above would also mean no further intervention in the process of financial innovation. Ideally, following this, the derivatives industry, arguably, the most creative segment of global financial markets would turn its considerable brainpower to finding solutions to pressing global welfare issues, such as the matter of perfecting a variety of derivatives insuring against bad harvests, unemployment, sudden financial hardship, and so forth. Innovative financial instruments and structured finance can indeed provide welfare enhancing solutions in these areas that could make a dramatic difference.

Naturally, most of the above sounds like a pipedream, but as Johan Wolfgang Goethe is famously quoted to have said, “[we should] dream no small dreams for they have no power to move the hearts of men.” While the financial rewards are not as promising, the pursuit of big goals that look like “dreams” is exactly what the global financial services industry needs right now to help it reclaim its legitimacy. And there is no worthier goal than assisting in economic development and poverty eradication through the use of human creativity and talent, both of which the financial sector can supply in abundance.


[1] The Governor of the BoE said in his Mansion House Speech: “It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure.” See “Mervyn King Presses His Case to Limit Size of Banks,” The Times, June 18, 2009, available at

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