from Global Economy in Crisis

Derivatives Plan a Watershed, but Risks Loom

Gillian Tett of the Financial Times assesses the new U.S. plan for regulating derivatives markets and says regulators must balance the need to create transparency against the risk of stifling financial innovation.

May 20, 2009

To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

The Obama administration recently unveiled a broad plan to regulate over-the-counter derivatives--privately-traded financial contracts through which investors can make bets (often very complex bets) on the price behavior of assets, debts, markets, or just about anything else. Credit default swaps, a particular kind of derivative through which investors can hedge against the potential default of financial instruments, played a central role in the financial crisis and raised questions about how derivatives should be regulated going forward. The administration’s plan would require the vast majority of derivatives to be cleared through central clearinghouses, such as regulated exchanges or electronic trading platforms. Given the breathtaking size of the derivatives market--news reports indicate there are more than $680 trillion in derivatives contracts outstanding--and given the tense political climate, the plan drew immediate attention.

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In this interview, Gillian Tett, who oversees coverage of financial markets at the Financial Times and has a new book out on the evolution of derivatives markets, points to an inherent tension between allowing for financial innovation and creating transparency in financial markets. She says there are two main risks as the plan goes through Congress: It could push financial business overseas, or unduly stifle innovation by limiting the ability of banks to create specialized, bespoke derivative products. She adds, however, that parts of the plan have been left ambiguous, probably intentionally, and that much remains to be seen about what it will look like after making its way through Congress.

Can you just describe the new regulatory plan and what it intends to do?

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The plan is a very interesting intellectual watershed or historical watershed. For the last nine years, since we had the Commodity Futures Modernization Act, there’s been a presumption that the OTC [over-the-counter] derivatives markets--those are the markets which are occurring off exchanges--were more or less outside the purview of any single regulatory authority. Banks who took part in those markets might be regulated because they were banks. But the products themselves were not regulated, and institutions such as hedge funds, which were active in the OTC market, were often not regulated in those trades almost at all.

What the new Obama plan is doing is essentially overturning or repealing not just the letter of that act, but also the spirit. It’s clear that there is no longer a presumption that it’s good to leave these markets unregulated and run in a free-wheeling way.

Instead what they’re doing are two main things. They are requiring banks and other institutions that play in these markets to post capital against their trades. At the same time, they’re also encouraging these markets to take place on centralized clearing platforms [like online trading platforms], if not full-blown exchanges. So that’s really quite a big shift.

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There are lots of different kinds of derivatives. What percentage of the market is made up of the sorts of over-the-counter derivatives that would need to be traded on regulated platforms now?

Well it depends which sector you’re looking at. In the credit derivate space, all of it has been OTC. So the type of shift we’re talking about could be quite significant. Even before these measures were announced, there were moves to put OTC credit derivatives activity on to clearing exchanges. When [U.S. Treasury Secretary Timothy] Geithner was president of the New York Federal Reserve, he was the key person driving that initiative forward. But actually enforcing that shift is definitely quite different from the regime we’ve had in recent years.

When you move to things like equity derivatives, in fact in America a large part of that--or a significant part of that--is already on exchanges. Less so in Europe. In the interest rate [derivates] space, it’s more or less half and half. So we’re talking about a pretty significant shift. Not a radical reform apart from the derivatives sector, but certainly a shift for the credit derivatives market that’s been at the heart of so much of the recent turmoil.

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Do you see major gaps in the plan or other problems with it?

What they haven’t stipulated very clearly in the plan is what they mean by "standardized" derivatives. They’ve made it clear that they expect "standardized" derivatives to move onto clearing systems, if not exchanges. And there’s a presumption that that will cover most products. However, "standardized" can be defined in many ways so there is a gray area there. In some ways it’s almost intentional--because what the Obama or Geithner plan really is is a set of proposals, a bid if you like, which they will be putting to Congress. One can probably expect to see some politicians asking for more, or pushing back, so there’s going to be a certain degree of negotiation ahead.

At the same time, there’s also a hope in the Federal Reserve and the Treasury that they will be able to use a number of incentives in terms of the fine details of how these plans are designed to encourage banks to start moving more and more of their activity onto regulated exchanges instead of just clearing platforms. There’s going to be a tiered process of capital charges. Essentially derivatives activity that happens on exchanges will require less capital reserves. If there is still activity occurring off clearing platforms--and that’s likely to apply to the most complicated, bespoke products--then banks will have to post very significant capital charges, as will hedge funds. So it’s hoped that that will act as a major deterrent.

The key point to grasp is that, at present, the U.S. authorities are not saying that they want all activity to move onto clearing platforms or exchanges. They want to leave a little window of opportunity for innovation. So ultra-specialized bespoke products will still be allowed to occur on a private, bilateral basis. But the hope is that by making it very expensive to do those kinds of trades, the banks and investors themselves will lose interest and move toward a more standardized, transparent world through their own initiative rather than through state diktat alone.

Are the accounting requirements that would go along with this particularly onerous? Some people have raised the parallel of when the government increased reporting and transparency requirements on the corporate bond market, and the result was that bank profits in that market got decimated. Might something similar happen here?

I think you put your finger on a very good point. It’s almost certain that as you introduce more standardization and transparency into the market, and as you force banks to post higher capital reserves against this kind of activity, it’s going to be much more costly for them to do it. So yes, profits will shrink.

Right now, I don’t think the banking industry is going to complain too much about that. The reality is derivatives activity is now viewed with so much suspicion by investors that if there is not significant reform, there will be pretty big question marks about the future of the industry anyway. But yes, it’s almost certain that as a result of these reforms, bank margins are going to be even further squeezed.

You mentioned already that there could be a fight looming in Congress. And clearly there’s a lot of populist anger at Wall Street at this point. Do you see potential for this legislation to get significantly distorted going through Congress? And what are the risks there?

Well there’s certainly going to be a very interesting debate about this legislation. What Geithner and company have set out is essentially a bid, if you want to use financial language. There’s a fair chance the banking industry will lobby hard to try to water it down. And there’s also a fair chance that the political sector will lobby hard to tighten it up. Many of the ambiguities of the plan are, I would guess, intentional. What some policymakers are hoping is that they will be able to use the finer details, that won’t be widely understood, as a carrot and stick to beat the banks and hedge funds to do what they want.

But it’s going to be very interesting to see, because a lot of what people are talking about involves some very complex, esoteric, technical issues that frankly are very badly understood outside banking circles and outside the world of a few regulators. But at the same time, the financial crisis has shattered the lives of many people and had a devastating political and economic impact which everybody can understand. So you’re moving at the same time into a very complex and technical world, but also one where there’s heightened tension and popular emotion.

On the technical, complex policy side, are there a few specific things you would highlight as what the biggest risks are in terms of going too far with this regulation? What would constitute going overboard?

What would constitute going overboard would be creating a regime where there is no more innovation, where banks can’t offer bespoke solutions to anybody at all. So if they clamp down too far, that’s one risk.

The other risk is that America clamps down alone and all its business goes off to London-or, if not London, than Monaco, or the Turks and Caicos Islands, or someplace like that.


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