Wednesday, November 18, 2009

Judd Gregg: OTC reform proposals in Washington miss the mark

Posted in the Financial Times by Judd Gregg:

The journalist H.L. Mencken once observed that, “complex problems have simple, easy to understand, wrong answers.” And, though modern history has amply demonstrated the resistance of complex political and economic systems to the easy answer of centralised control, we try time and again to apply top-down solutions to our multi-faceted problems.

This conflict is brought into no sharper light than by Congress’s current efforts at financial services reform; particularly those directed at the labyrinthine world of the multi-trillion over-the-counter dollar derivatives trade.

Derivatives are a vital and complex component of modern financial markets, making it imperative that reform be done right – without damage to the twin pillars of innovation and capital formation.

The question as to how derivatives should be regulated is not easy to answer, but Congress should start with some guiding principles. First, derivatives regulation should seek to foster a robust, competitive and liquid marketplace. Second, systemic counterparty risk exposure must be reduced by incentivising central clearing and increasing reporting requirements to promote transparency. Third, regulation must preserve the ability to engage in bilateral customised transactions for risk management. Finally, we must co-ordinate our efforts with the international community to prevent global regulatory arbitrage and the flight of capital to less regulated jurisdictions.

Unfortunately, the regulatory reform proposals making their way through both chambers of Congress fail to take into account the intricacies of this dynamic financial product and expose a fundamental misunderstanding of the way in which the marketplace works. Congress must think through the significant, unintended consequences before we act to mandate that all OTC derivatives be centrally cleared and executed on exchanges or cash collateralised, as well as subjecting end-users to capital charges. By de-incentivising companies to use these risk management tools, such proposals will have the perverse effect of increasing business risk and raising costs.

The proposals advocated for by the US Treasury and chairman of the senate banking committee, senator Christopher Dodd, seem to provide too many government mandates and not enough flexibility. The proposed regulatory structure for OTC derivatives is built on an inadequate foundation lacking the staff, expertise, technology, and resources needed to provide truly robust oversight. Clearing and exchange-trading requirements do not accommodate the need for customised transactions. Capital and margin requirements threaten to lock up liquidity. Lack of international co-ordination guarantees a flight of capital away from our shores.

Derivatives may not be part of the Main Street vernacular, they may be unfamiliar to the local car dealership, but the manufacturers that supply those dealerships know them well. Derivatives provide businesses with access to lower-cost capital, enabling them to grow, invest, and retain and create new jobs. With the unemployment rate at 10.2 per cent nationally, this is no time to increase uncertainty and business costs.

Congress must be mindful of the mobility of capital in the global marketplace as well. Without a proper regulatory balance, capital can and will accept higher risk for less onerous regulation. We must maintain incentives for business to participate in a large and liquid OTC derivative market, while promoting global coordination to minimize regulatory arbitrage and systemic risk.

Under current proposals, capital requirements that will be imposed on OTC dealers will pass on additional cost to end-users. Coupling these capital costs with a decreasing ability to customise transactions could result in sharply lower usage by end-users. Given that 94 per cent of Fortune 500 companies use customised OTC derivatives to manage macro-economic risk, providing less certainty to corporate balance sheets will severely undermine confidence in the American marketplace.

Further, the proposal to mandate exchange trading makes little sense in the bespoke OTC derivatives market. The basic assumption of exchange trading reflects the use of standard products. OTC derivates by their very nature are not always standard. In the real world, mandating use of an exchange would inhibit the use of such customised derivates that are useful financial management tools to hedge extremely specific risks. Bespoke derivatives cannot always be substituted with exchange traded or standardised OTC products. Even attempting to craft a carve-out for such derivatives raises the concern of whether the Securities and Exchange Commission and Commodity Futures Trading Commission could agree on what should be traded.

Another red flag raised by the circulating proposals is the unintended consequence of segregating variation margin. The more capital a dealer has to set aside to purchase an asset, the fewer assets it can purchase. Heightened capital requirements restrict a dealer’s ability to generate returns on its capital or provide loans to Main Street businesses, students heading to college, or families seeking a mortgage. It also does not protect end users or reduce systemic risk in any demonstrable way.

Corporate scandal and economic failure have provided such a regulatory catalyst many times in the past. It is alarmingly reminiscent of 2002, when Congress enacted Sarbanes-Oxley; introducing a host of new compliance requirements for accounting, corporate governance, and financial disclosure. But, in the years since the legislation took effect, the overhaul has come to be widely regarded as overly complex, unduly burdensome, and a severe disadvantage to American businesses in the global marketplace.

Congress should be instructed by the lessons of the past and not add such regulations that will impede capital formation. The simple, easy, but ultimately wrong answer is to issue a government mandate for every perceived problem. Thinking through the unintended consequences of over-regulation and trusting market solutions is more difficult, but it is ultimately the only way to preserve the innovation that powers American markets.

Judd Gregg, a Republican senator from New Hampshire, is ranking member of the Senate budget committee and a member of the Senate banking committee. He was also the chief Republican senate negotiator for the Troubled Asset Relief Programme (TARP)

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