Wednesday, October 21, 2009

Scope remains to circumvent derivatives bill

Posted in the FT by Robert Engle:

The House financial services committee in the US last week approved a bill to deliver sweeping changes to the structure and regulation of the massive over-the-counter derivatives business.

This bill goes far in reducing counterparty risk in the OTC derivatives market and the systemic costs of bankruptcy of a large sector participant. The process of closing positions and managing exposures will be much easier. The proposal also should reduce transaction costs in swap markets and improve price discovery. Furthermore, participants will save the cost of credit insurance which is typically taken out against counterparty defaults.

The bill requires that most standardised swaps will be traded on a swaps exchange facility or an electronic exchange. Once a large swap participant accepts the standardised contract offered, it will be executed against a central counterparty. The participant will be required to post a margin to ensure the central counterparty is able to meet its commitments to all of its counterparties. The margin required will vary as the position gains or loses money. If some participants become insolvent, then they will forfeit their margin balance which should be sufficient to avoid substantial losses to the system. The data from these transactions will be reported to a registry and aggregated versions made public.

Contracts without an electronic market will be traded bilaterally. But in contrast to current practice, regulators will set margins at least for large swap participants and dealers. All such non-cleared contracts will be reported to the registry which will be visible by the regulators so they can see interconnections. Capital requirements against these non-cleared positions will be set at a higher level than for cleared transactions reflecting increased risks.

The bill also exempts end-users who are not large swap participants from the requirement to post margins or clear standardised products. But it empowers regulators – the Security and Exchange Commission and the Commodity Futures Trading Commission – to designate market players as major swap participants if they take big and systemically risky positions. Thus excluded end-users can be brought under the regulatory umbrella.

Yet some exceptions in the bill deserve more careful examination. Slightly non-standard contracts can be traded bilaterally and only reported to the repository. This structure may encourage financial innovation designed only to keep products from central clearing. Regulators will be obliged to set margins and capital requirements for these new and potentially complex products but they may be unable to keep up with the flood of variations.

An alternative and much simpler solution is available: transparency. If such transactions were required to be posted on a public site with information on counterparties and, importantly, their margining arrangement, the risk of a bilateral deal with any counterparty could be more accurately assessed. The market would price the counterparty risk and this would provide a far more powerful disincentive to excessive risk taking than the threat of regulatory capital requirements. Third parties would assemble this data and sell credit information to market participants. A swap participant that does not want its transaction made public would have an incentive to move to a cleared product.

Several other extensions should be pursued. Margins should be netted across clearing structures. That is, if a position in interest rate swaps is positive and in credit default swaps is negative, the margin to be posted should be the difference between these. Similarly, international co-ordination should allow for margins across geographical areas to be netted. Finally, the accounting treatment of hedge positions may require further flexibility.

This bill has the potential to reduce the likelihood and severity of future financial crises. But in its current form, it leaves loopholes that a healthy financial sector will find all too easy to arbitrage round.

Robert Engle teaches at the Stern School of Business at the University of New York and is the 2003 winner of the Nobel Prize in Economics. This article was co-written by Viral V. Acharya, who also teaches at the Stern School

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