Friday, November 27, 2009

Keeping Derivatives in the Dark

Posted in the New York Times by Floyd Norris:

Opaque markets breed insider profits and abuse of investors. Sunshine can bring competition and lower costs even if regulators do little beyond letting the sunlight shine.

You might think that as Congress considers just how much regulation is needed for the shadow financial system — the one that largely escaped regulation in the past — letting in such light would be an easy and uncontroversial move.

But it is not proving to be easy at all, and is one part of the Obama administration’s financial reform package that is most in jeopardy.

Timothy Geithner, the secretary of the Treasury, will testify before the Senate Agriculture Committee next week in an effort to hold on to important provisions of the proposal that have come under attack by banks fearful of losing one of their most profitable franchises — the selling of customized derivatives to corporate customers. Remarkably, the banks have persuaded customers that keeping the market for those products secret is in their interest.

Last week, Gary Gensler, the chairman of the Commodities Futures Trading Commission, faced the same panel, and ran into questions that indicated at least some senators were sympathetic to efforts to keep large parts of the derivatives market in the dark.

Those markets allow companies to bet on — or, if you prefer, hedge themselves against losses from — changing interest rates and commodity prices. They also allow investors to use credit-default swaps to bet on whether a company will go broke. The administration wants to standardize those products when possible, and force the trading of them onto exchanges when possible.

Banks want to whittle away the reforms if they can, and to minimize the roles of the C.F.T.C. and the Securities and Exchange Commission, experienced market regulators who have been generally kept away from over-the-counter derivatives in the past. Instead, the banks would like to leave it to banking regulators to oversee the dealers, something regulators totally failed to do in the past. Unless Mr. Geithner can persuade legislators otherwise, one of the great bank lobbying campaigns will have succeeded, in large part because some companies that buy derivatives from banks have been persuaded that their costs will rise if needed reforms were made.

The opposite is probably true. The history of nearly all markets is that customers suffer if dealers are able to keep them ignorant of what is actually going on.

Until the beginning of this decade, that was true in the corporate bond market, where actual trades were kept confidential. That made it easy for bond dealers to charge big markups when they sold bonds to customers.

After regulators forced timely disclosures, the bid-ask spreads — the difference between what customers paid when they bought bonds and what they could get when selling them — declined significantly. The result was smaller profits for bond dealers, and better returns for bond investors.

“It is now time,” Mr. Gensler testified, “to promote similar transparency in the relatively new marketplace” for derivatives traded over the counter.

“Lack of regulation in these markets,” he added, “has created significant information deficits.”

He listed “information deficits for market participants who cannot observe transactions as they occur and, thus, cannot benefit from the transparent price discovery function of the marketplace; information deficits for the public who cannot see the aggregate scope and scale of the markets; and information deficits for regulators who cannot see and police the markets.”

In the listed markets for derivative securities, like futures, there are margins that must be posted every day if markets move against the buyer of the derivative. Corporate customers of over-the-counter derivatives fear that they might face similar margin requirements if their contracts were to be traded on exchanges, and have persuaded some legislators that would be horrible.

Of course, because prices aren’t made public, we can only hope that the banks currently are pricing the credit at reasonable levels. The banks say they are. Robert Pickel, the chief executive of the International Swaps and Derivatives Association, an industry group, assured me this week that “the cost of credit is taken into account in the collateral relationship and in the bid-ask spread.”

In layman’s terms, that means that customers with worse credit would face different prices than customers with excellent credit, which Mr. Pickel argued would make price disclosure of limited value.

Mr. Gensler, the C.F.T.C. chairman, argues that customers would be better off if the two markets — for the derivatives and for the credit — were separated and had clear pricing. “How else,” he asked in an interview, “can customers know if they are getting fair prices?”

Remarkably, big corporations like Boeing, Caterpillar and many others that use derivatives to hedge risk have been persuaded by bankers that they should not worry about that.

If over-the-counter derivatives were to be traded on exchanges, or centrally cleared, or subject to margin requirements, a host of corporate trade associations and companies said in a recent letter to legislators, such reforms “would inhibit companies from using these important risk management tools in the course of everyday business operations. These proposals, which would increase business risk and raise costs, are at cross purposes with the goals of lowering systemic risk and promoting economic recovery.”

Reflected in that letter is a belief that the banks, in designing and selling derivatives to customers, are acting as trusted advisers, looking out for the best interests of their customers. Every so often, one of these deals blows up and winds up in court. Then the banks argue that they were simply counterparties, with no responsibility for the wisdom, or lack of same, shown by the customers.

If, as seems likely, Congress chooses to eliminate or minimize the disclosure of customer trades, and if it allows custom derivatives to remain almost completely opaque and without visible pricing of credit, that will encourage some corporate customers to prefer customized contracts. Such contracts will probably cost them more, but the cost of credit will be hidden, and they may not have to post collateral immediately if they are losing money.

For Mr. Geithner, this legislative battle may indicate whether he still has the ability to persuade legislators, or whether he has become the political liability that at least some Republicans think he is. When he ventured to Capitol Hill earlier this month, one congressman suggested he should resign.

If Mr. Geithner is vulnerable, it is because the efforts of the administration and the Federal Reserve to save the banking system worked too well. The fears of collapse that were present early this year have faded away, and been replaced by a general feeling of resentment.

The banks seem to be on the verge of harnessing that feeling of resentment to preserve a major profit center. In terms of lobbying, it will be a remarkable achievement.

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