Wednesday, April 14, 2010

Bob Litan on Derivatives Reform (Rortybomb's take)

Original posted on Rortybomb (Part One and Two):

Bob Litan of the Brookings Institute has a new paper out on derivatives reform (full pdf, summary). The paper is called “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties” and it’s a must read for two very important reasons.

Before we get there, I agree with his recommendations for regulating the over-the-counter derivatives market and especially the credit default swap market (CDS): create a strong presumption for over-the-counter derivatives to go through clearing, and to be traded on an exchange with pre-trade price transparency. Those that can’t should have margins posted and have post-trade price and volume transparency. This will be a major battle ground in the financial reform debate, and learning these terms will put you in a better spot to follow it. Litan walks you through each of the terms.

As his title states, Litan is worried about the “Dealer’s Club” of the major derivatives players. I particularly like this paper as the best introduction to the current oligarchy that takes place in the very profitable over-the-counter derivatives trading market and credit default swap market. I’m going to just give the high level overview of what he says (italics in original, my bold):

I have written this essay primarily to call attention to the main impediments to meaningful
reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks…I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being
widely discussed are adopted
— that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned…

Here, of course, I refer to the major derivatives dealers – the top 5 dealer-banks that control virtually all of the dealer-to-dealer trades in CDS, together with a few others that participate with the top 5 in other institutions important to the derivatives market. Collectively, these institutions have the ability and incentive, if not counteracted by policy intervention, to delay, distort or impede clearing, exchange trading and transparency

Market-makers make the most profit, however, as long as they can operate as much in the dark as is possible – so that customers don’t know the true going prices, only the dealers do. This opacity allows the dealers to keep spreads high…

In combination, these various market institutions – relating to standardization, clearing and pricing – have incentives not to rock the boat, and not to accelerate the kinds of changes that would make the derivatives market safer and more transparent. The common element among all of these institutions is strong participation, if not significant ownership, by the major dealers.

So Bob Litan is waving a giant red flag that the top dealer-banks that control the CDS market can more or less, through a variety of means he lays out convincingly in the paper, derail or significantly slow down CDS reform after the fact if it passes. Who are these dealer-banks?

Litan never names them, but footnote 39 refers to the top 5 banks/BHC at the OCC’s Quarterly Report on Bank Trading and Derivatives Activities controlling 96%-97% of the market for the top 25 BHCs. And from there, the top four are: 1. JPMorgan Chase (assets: $2,000bn) 2. Goldman Sachs ($850bn) 3. Bank of America ($2,200bn) 4. Citibank ($1,856bn). This doesn’t get at the entire market, as the OCC only can see US commercial bank data, but it gives you a sense of the players.

Litan never mentions this as part of a group of solutions, but It is worth noting that these four players, all TARP recipients, would be turned into 15 players with a size cap of around $500 billion dollars. There are good arguments against a size cap, but the two leading ones, (1) that there would be a cluster of banks around the cap and (2) the broken pieces would be perfect clones of the whole piece, aren’t at all relevant for the issue of an oligarchy capable of derailing credit default swap regulation and colluding to keep the margins high through market and institutional control.

If you thought we’d at least get our arms around credit default swap reform from a financial reform bill, you should read this report from Litan as a giant warning flag. In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have. It’s not Matt Taibbi, but it’s much further away from a “everything is actually fine and the Treasury is in control of reform” reassurance. Which should scare you, and give you yet another good reason for size caps for the major banks.

Regulators not mounting up?

How did the credit card bill of last year sweep through Congress so easy, when more general consumer financial protection and derivatives reforms are stalling? Credit default swaps made the crisis obviously worse, but credit cards didn’t appear to play a major role. I’m not the best government watcher, but I do know there was one element to the story that made it easier: the Federal Reserve signaled that it was going to implement those rules through its regulatory discretion. From Reuters May 22nd, 2009: “The [credit card] law largely codifies a set of rules issued by the Federal Reserve last year and puts them into effect in February 2010, five months sooner than the Fed had planned.”

Your initial reaction may be that this is a cynical move, that the Federal Reserve was going to do something it should be doing but Congress want to be able to take credit for it. But that’s backwards. The Federal Reserve is giving cover and protection to Congress from lobbyists and influential donors to pass a bill that will ultimately tie the hands of the Federal Reserve to commit to this action. They reinforce each other by behaving this way – the law codifies with clear rules a floor of regulation on what the Federal Reserve needs to do, and the Federal Reserve allows Congress to go “what could I do? The Federal Reserve was going to do this anyway” when it comes time to vote (and raise donations).

Bob Litan asks the obvious question in his derivative dealers paper: Why don’t the regulators go ahead and get started on regulating credit default swaps and other OTC derivatives, or at least aggressively signal that they will do so if Congress fails or if Congress passes a weak derivatives bill? From the paper (my bold):

As a threshold matter, I argue that the current regulators of derivatives markets…have authority to take a number of measures to ensure meaningful reform, regardless of whether Congress enacts some version of the House or the Dodd bills. I want to be clear: statutory reform remains essential, and generally speaking regulators should wait until Congress finishes its work on reform legislation. But regulators are not powerless even under existing law and should take action if legislative reform fails this year, and possibly in some cases even before.

First…the judicious use of capital charges on trades that are not centrally cleared or exchange traded. The Federal Reserve has this ability now and should use it…Second…regulators could require the exchanges to implement both pre-trade and post-trade transparency…Third, regulators could compel governance reform of ICE Trust…Fourth, regulators can and should impose a series of non-discrimination requirements. …Fifth…if the antitrust authorities find broad abuses by dealers and/or entities they control or they could limit dealers to a minority, non-controlling ownership position.

It is laid out in detail in the paper, but capital charges on non-exchange with clearing traded derivatives, or derivatives that trade in the dark. Pre and post trade transparency. Ownership reviews. And a word the administration needs to get behind if it wants to get serious about reform: antitrust. This sounds exactly like what the best administration package would end up doing, and Litan emphasizes the systemic risk portion but I really want to emphasize the election cover portion of it.

Having the regulators already moving on this would help get something not terrible out of the AG committee. If there’s a strong challenge, it gives strength to Congress to say “we really do need to pass serious reforms, the biggest financial players are fighting us hard here.” If there isn’t, then Congress can say “we really don’t have a choice”, and can lock in the regulators into doing the right thing.

So why aren’t we doing this much more strongly than any current efforts? I don’t know. We can go back to then Treasury deputy secretary Larry Summer’s testimony from July 30th, 1998 where he argued against regulating the over-the-counter derivatives market in the first place:

As you know, Mr Chairman, the CFTC’s recent concept release has been a matter of serious concern, not merely to Treasury but to all those with an interest in the OTC derivatives market. In our view, the Release has cast the shadow of regulatory uncertainty over an otherwise thriving market — raising risks for the stability and competitiveness of American derivative trading. We believe it is quite important that the doubts be eliminated….

In this testimony I have put forward some of the considerations that Treasury believes ought to be kept in mind in approaching a resolution of these issues going forward. But this should not distract from our basic point: that any further clarification of the situation, not to mention any new regulation of this market, ought to come with the legitimacy of a clear legislative mandate from Congress.

Back then it was don’t do sensible financial regulation lest we lose international competitiveness argument. The same reason we aren’t writing in a leverage requirement.

But look at the second part. I also agree that a legislative mandate would be nice before regulators start to signal and/or actually move on regulating credit default swaps. But without a strong signal that “clarification” of a market that put taxpayers on the hook for $200 billion dollars with AIG is coming one way or the other through the regulatory infrastructure already in place, getting a decent law to move in our money saturated politics is going to be impossible.

I bet Summers gets this now. But does Treasury and the Federal Reserve?

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