Regulating Derivatives : The Case for Incentives

Increased regulation of derivatives is coming. At least that was the consensus view of the participants at a recent breakfast discussion I attended “Regulating Derivatives in the Wake of the Financial Crisis”, hosted by FinReg21. The discussion was lead by former SEC Commissioner, Edward H. Fleischman who is currently the Chair of the International Securities Regulation Committee of the International Law Association, and Professor Stephen Figlewski, Professor of Finance at the NYU Stern School of Business and editor of the Journal of Derivatives. The participants included a representative cross cut of the legal and business communities involved in these instruments.

This isn’t a surprising conclusion given there are submitted bills and bills in formation in Congress and a Treasury plan on the table. Although there is overlap in the provisions of these competing plans there are some significant differences in several key provisions. In no particular order here goes my take on the key issues in this discussion.

1. Derivatives should only be used for hedging purposes. Translated that means derivative trading will end at least in this country. If only hedging is permitted then every hedger will be put in the difficult position of finding another hedger with the opposite exposure. Speculators serve a real economic purpose in providing liquidity and making markets more efficient. There are plenty of orderly, stable markets rife with speculators. Take the cash market for U.S. Government bonds, or futures for example, which gets me to point 2.
2. Most if not all derivatives should be exchange traded. This is one way of addressing the transparency issue. Exchange traded instruments are transparent and OTC derivatives for the most part are not. Therefore, requiring OTC derivatives to be exchange traded will make them transparent. Logical but impractical. The popularity of OTC derivatives is at least in part due to the market’s capacity to tailor instruments to reflect precise risk exposures. Tailored instruments do not succeed on exchanges because the number of participants interested in trading the same tailored exposure is likely to be quite small; certainly not enough to justify an exchange listing. Therefore some exclusion has to made for tailored derivatives; however implementing that exclusion is not so easy as will be discussed below.
3. Derivates should be cleared by a centralized facility (or facilities). This is a solid idea. Besides promoting transparency central clearing reduces counterparty risk assuming of course that the clearing agents are sufficiently well capitalized to actually guarantee the trades they settle. Confidence in the financial cushion provided by centralized clearing would benefit from having more than one agent; how many is optimal is a discussion for another time.
4. Derivatives should be standardized (at least as much as is practical). Standardization facilitates exchange trading, but since exchange trading is really not necessary for greater transparency and is not a realistic objective for the entire market, who cares. Standardization would also clearly facilitate central clearing and about this I do care. Although a non standard instrument could be centrally cleared it does not follow that all centrally cleared instruments could be non-standard. It would likely place too great a burden on the clearing agents.
5. Given that there is benefit to standardization how would it be implemented or enforced? Would teams of attorneys lay out in precise detail the terms and conditions of each standardized derivative? And even if they did how long would it take to re-engineer standardized derivatives and make them non-standard? Why you might ask would anyone favor non-standardized derivatives? See 6.
6. The answer is money. Opaque markets are more profitable than transparent markets, and therefore dealers will have a bias against transparency. Many recent innovations in fixed income markets are in part explainable as an ongoing march to create the next successful opaque, and highly profitable, market. OTC derivatives are a relatively recent manifestation of that motivation. There are OTC derivatives currently traded that appear to generate sufficient volume to support being exchange traded but there has been no groundswell of support from dealers to list them. Although I am not in favor of exchange trading requirements as discussed above centralized clearing, which I do favor, will also benefit from standardization. The question then is how to promote centralized clearing?
7. I prefer incentives to mandates. Capital requirements can be used to encourage market participants to favor clearing their derivative trades in a centralized facility. Make it more expensive to keep trades away from such facilities by specifying greater required capital for OTC derivatives that are not centrally cleared. Then dealers are incented to make their trades conform to standards required by a centralized clearing agent. Only when the cost of clearing is so great that it approaches the magnitude of the capital charge would a dealer be inclined to favor clearing direct rather than central clearing. That situation is likely to occur for those derivatives that must be tailored to work and are sufficiently different so that clearing is made complex. Further the cost of direct clearing would have to be significantly lower to compensate for the difference in capital requirements.
8. Centralized clearing is not my idea. It has floated through a number of proposals including the one authored by the administration. Academics and analysts have also gotten behind the idea. The hard part is how to set the differential capital requirements. Set them too high and the idea is a non-starter. Set them too low and there is no incentive to move to central clearing. Finding the Goldilocks levels for capital requirements is complex and possibly even intractable. Some regulatory authority cajoling in additional to capital requirements may be needed to ensure success. Regardless, the more we can rely on objective capital requirements that provide incentives to encourage centralized clearing for the vast majority of, if not all, derivatives so much the better.

Ben Wolkowitz Headstrong September 27, 2009

ISDA Mid-Year 2009 Market Survey Shows Credit Derivatives at $31.2 Trillion

Source :: http://www.isda.org/press/press091509.html

NEW YORK, Tuesday, September 15, 2009 – The International Swaps and Derivatives Association, Inc. (ISDA) today announced at its 2009 Regional Conference in New York the results of its Mid-Year 2009 Market Survey of privately negotiated derivatives.

“The derivatives business overall showed consistent growth in the first half of 2009, demonstrating the need for customized risk management solutions to help navigate the more uncertain economic landscape,” said Eraj Shirvani, Chairman, ISDA and Head of Fixed Income for EMEA at Credit Suisse. "This continued growth is a testament to both the utility of derivative instruments and to the industry's ongoing efforts to reduce risk and enhance operational efficiency."

"These survey results reflect the continued resiliency of the privately negotiated derivatives industry and its benefit to businesses globally," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The reduction in CDS outstanding highlights the great progress made through the industry's implementation of operational enhancements, in particular through its achievements in portfolio compression."

According to the Survey, notional amount outstanding of credit derivatives decreased by 19 percent in the first six months of the year to $31.2 trillion from $38.6 trillion. Over the preceding twelve months, credit derivative notional amounts decreased by 43 percent from $54.6 trillion at mid-year 2008. For the purposes of the Survey, credit derivatives comprise credit default swaps referencing single names, indexes, baskets, securitized obligations, and portfolios.

Notional amount outstanding of interest rate derivatives, which include interest rate swaps and options and cross-currency swaps, grew by 3 percent to $414.1 trillion from $403.1 trillion. This compares with a 13 percent decrease from $464.7 trillion during the second half of 2008. Over the preceding twelve months, interest rate derivatives decreased by 11 percent from $464.7 trillion in mid-2008.

Notional amount outstanding of equity derivatives, which consist of equity swaps, options, and forwards, remained relatively flat at $8.8 trillion. This compares with a 27 percent decreasefrom $11.8 trillion during the second half of 2008. The annual growth rate for equity derivatives to mid-2009 decreased by 26 percent to $8.8 trillion from $11.8 trillion at mid-year 2008.

The above notional amounts, which total $454.1 trillion across asset classes, are an approximate measure of derivatives activity, and reflect both new transactions and existing transactions. The amounts, however, are a measure of activity, not a measure of risk. The Bank for International Settlements (BIS) collects both notional amounts and market values in its derivatives statistics and it is possible to use the BIS statistics to determine the amount at risk in the ISDA survey results.

As of December 2008, gross mark-to-market value of all derivatives was approximately 5.7 percent of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.8 percent of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of $454.1 trillion as of June 30, 2009, gross credit exposure before netting is estimated to be $26.0 trillion and credit exposure after netting, but before collateral, is estimated to be $3.8 trillion.

The ISDA Mid-Year 2009 Market Survey reports notional amounts outstanding for the interest rate derivatives, credit default swaps, and over-the-counter equity derivatives as of June 30, 2009. All notional amounts have been adjusted for double counting of inter-dealer transactions. ISDA surveys its Primary Membership twice yearly on a confidential basis. In this survey, 86 firms provided data on interest rate swaps; 78 provided responses on credit derivatives; and 77 provided responses on equity derivatives. Although participation in the Survey is voluntary, all major derivatives houses provided responses.

^®ISDA is a registered trademark of the International Swaps and Derivatives Association, Inc.