Tuesday, April 20, 2010

Swaps showdown (FT Editorial)

A year has passed since the Group of 20 leaders meeting in London swore to regulate the global financial system so it would not blow up again. Neither Europe nor the US has managed to pass reform. Still in the balance are the future rules for derivatives trading.

Original posted in the FT:

In the US, a showdown is at last in sight. The House of Representatives has passed its financial regulation bill. The Senate version, long caught in the backwater of Democratic senator Chris Dodd’s efforts to craft compromises with Republicans, has emerged from Mr Dodd’s committee. But the derivatives chapter of the bill remains up for grabs on the Senate floor.

The crisis showed beyond any doubt that derivatives channel systemic risk: it was ill-judged credit default swaps that brought AIG to its knees. This should not have been a surprise: derivatives are after all a way of making leveraged bets. But they are also invaluable risk management devices, and calls for banning them outright are misguided. The main thrust of proposals by both the European Commission and the US administration has it right: move derivatives out of opaque over-the-counter dealing to central clearing and exchange-based trading. The transparency and competition this would bring to derivatives markets would narrow spreads, give truer prices for risk, and make it easier to require adequate capital to back the bets taken through derivatives.

It is increasingly likely that this will be enshrined. A bill taken up by the Senate agriculture committee, which Mr Dodd may adopt, lets regulators strictly limit OTC derivatives trading. So do Brussels’ plans. The politics have swung behind real reform: Barack Obama has threatened to veto any bill he deems too weak on derivatives.

A contentious issue is exemptions for non-financial companies using derivatives to hedge against price swings. They plead mercy on the grounds that exchanges cannot offer the tailored swaps they need and that they cannot afford the collateral central clearers demand.

Tim Geithner, US Treasury secretary, pushes for minimal exemptions. He is right: non-financial hedging should not be exempt. Some customised products will still have to trade over the counter; but the point of collateral and capital requirements – to price risk correctly – is no less important for industrial counterparties than for banks. Financing may be dearer as a result – rather the point after a credit bubble. If so, the response is to ensure that capital and liquidity ratios are appropriate – not leave open ways to get round them.

Pushback from European Association of Treasurers:

Deep in the Financial Times there’s an editorial desk that occasionally peddles the line that industrial companies are bleating unreasonably about the threat of OTC derivatives regulation. Their editorial today asserts that non-financial hedging should not be exempt from the requirement for central clearing under proposed new derivatives regulation and makes the fundamental error of confusing the reasons why underpricing of risk brought the financial system to its knees.

I’ve written to the FT (but they may be fatigued with hearing from me) pointing out that legislators on both sides of the Atlantic are struggling with the detail of how to deliver on the G20 commitment to regulate derivatives precisely because the creation of systemic risk – triggered in the financial crisis by underpricing of risk amongst other factors – is not attributable to derivatives transacted by non-financial end users. Without such a justification for the inclusion of these end users the only solid foundation for the aggressive approach the FT endorses seems to be safeguarding the political skins of Congressmen and MEPs, who find the approach politically helpful even if counter to the long-term interest of their constituents.

The reality is that a regulatory outcome that forces end users into central clearing will drain huge funding from productive investment and working capital and create additional economic and employment volatility as companies reduce their hedging; it will do nothing to reduce systemic risk. I remain optimistic that commonsense will prevail in Brussels if not in Washington.

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