Monday, April 12, 2010

The Derivatives Dealers’ Club and Derivatives Markets Reform

Original posted on the Brookings website by Robert Litan:

Mention the word "derivative" outside of a narrow circle of Wall Street and Chicago traders and other market participants, and you’re likely to get one or several of the following reactions: fear, anger, or disinterest. Warren Buffett has famously analogized derivatives – financial instruments whose value depends on and thus is “derived” from the value of some other underlying security, such as a stock or a bond or the current price of a commodity – as "financial weapons of mass destruction." Who wouldn’t be afraid of such things? Or, if the widespread condemnation of derivatives for causing or helping to cause the recent financial crisis is accurate, who wouldn’t be angry at them? Meanwhile, those who might not care about the word or the complex issues it raises can be forgiven. After all, derivatives are difficult for non-experts to understand and seem unrelated to every day things most people really care about in times like these – such as their jobs and how they will be able to pay for their children’s education or their own retirement.

But whether you know it or not (or care), derivatives have become crucial parts of the financial and economic system not only in this country but elsewhere around the world. Derivatives such as futures and options contracts, and various kinds of “swap” arrangements (involving interest rates, foreign currencies, and loan defaults), provide efficient ways for both financial and non-financial users to hedge against a variety of financial risks. The numbers involved run into the hundreds of trillions of dollars in “notional” amounts, though the amounts actually at risk are substantially lower. Moreover, when properly used and backed by sufficient collateral, derivatives have become a valuable financial tool for banks and wide variety of end-users: corporations and private companies, state and local governmental entities, and so-called “buy-side” non-bank financial institutions.

Derivatives got their bad reputation during the financial panic in September 2008, when the world learned that if the parties to both sides of the transactions are large, financially connected with many other parties, and do not have the financial means to make good on their promises, derivatives that are traded “over the counter” (OTC) and not centrally cleared can pose dangers to entire economies. The dangers are especially great for one kind of derivative contract on which I concentrate primarily here – “credit default swaps” (CDS). With CDS, non-defaulting parties (the buyers of this particular kind of insurance against loan or bond default) are likely, especially in an economy-wide crisis, to find it more expensive to replace their contracts with the defaulting party (the seller) than are non-defaulting parties in other OTC swap arrangements. Indeed, mainly for this reason, unless otherwise indicated, when I refer in this essay to “derivatives” I mean specifically CDS, although many of the arguments or claims I advance refer to other OTC derivatives as well.

Fortunately, there is a growing consensus among financial regulators and academic experts about what to do at least with respect to “standardized” derivatives, or those that resemble readily traded stocks or futures contracts, and thus how to help keep financial actors who are heavily engaged in derivatives activities and also run into financial trouble from infecting other institutions and conceivably entire markets. I will outline this consensus shortly, which may be enacted in some form by Congress this year as part of comprehensive financial reform.

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. The dealer banks, in turn, transact heavily with each other, to hedge the risks from their customer trades and somewhat less frequently, to trade for their own accounts.

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. At the end of this essay, I will outline a number of steps that regulators and possibly the antitrust authorities may be able to take to overcome any dealer resistance to constructive change.

Download paper here:

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