Finally had a chance to look over the much anticipated Treasury White Paper on “reforming” financial regulation. It’s a long document, addressing many issues with which I am not that conversant, so I will focus my attention on the Paper’s recommendations for OTC derivatives.
The Paper begins its analysis with an extended discussion of what it asserts was a “lax regulatory regime for OTC derivatives–and, in particular, for credit default swaps” (p. 44):
In the years prior to the crisis, many institutions and investors had substantial positions in CDS–particlarly CDS that were tied to asset backed securites (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated market participants. At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against the decelines in the value of such ABS, as well as poor counterparty risk management by many banks, saddled our financial system with an enormous–and largely unrecognized–level of risk. When the value of the ABS fell, the danger became clear. . . . Lacking authority to regulate the OTC derivatives amrket, regulators were unable to identify or mitigate the enormous systemic threat that had developed (pp. 44-45).
Based on this rather tendentious reading of the history of highly non-standardized, illiquid instruments, and on this reading alone, the Treasury makes the following policy recommendation:
To contain systemic risks, the Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).
This has to be one of the most collossal non-sequiturs on record. Highly non-standardized financial derivatives allegedly led to a systemic crisis–so we should mandate clearing for standardized products. As an exercise in logic, by comparison to this the “Burn the Witch” scene in Monty Python in the Holy Grail is a model of precise reasoning.
Thus, as has been true all along, the case for clearing of standardized OTC derivatives levitates, with no evident means of logical or empirical support. This could be a great Vegas magic act.
In retailing, this is known as the “bait-and-switch.” Regulators often punish stores that engange in such conduct. Here, we’re out of luck–because the regulators are the ones perpetrating the bait-and-switch.
A coherent case for mandating clearing would require a demonstration that OTC derivatives suitable for clearing pose a systemic threat, at least illustrated by anecdotes analogous to the now tired arguendo ad AIG. (The absence of any such anecdotes is very, very telling–not to mention that argument-by-anecdote is a very de minimus standard because “data” is not the plural of “anecdote.”) What’s more, the argument would require a rigorous comparative analysis of the systemic risks posed by alternative mechanisms–bilateral and centrally cleared. Instead, we are repeatedly entertained by next part of the magic act: assertions that clearing makes these risks disappear!
Even the arguendo ad AIG has its defects. To wit:
- If “the most sophisticated market participants” failed to recognize the risk characteristics of the CDS on ABS, how possibly could one expect a CCP to do any better? Yet another magic trick: the CCP as deus ex machina, that magically appears to solve all of the difficulties that had stumped the most sophisticated. Indeed, if anything, the CCP is likely to be a less sophisticated evaluator of risks. So wouldn’t forcing things onto clearinghouses potentially make things worse?
- “Excessive risk taking by AIG and the monolines . . . saddled our financial system with an enormous . . . level of risk.” This betrays a serious misunderstanding of the role of derivatives. As I argued in It’s a Wonderful Life, AIG Edition, AIG et al took on existing risks associated with existing ABS. If AIG et al hadn’t taken on the risk, it would have remained somewhere else in the financial system. And it’s almost certain that it would have remained with Goldman, SocGen, DB, etc. So, if the decline in ABS prices was so big to threaten the existence of those firms unless AIG paid off on its CDS, their existence would have been even more threatned without AIG’s equity absorbing a portion of the loss. The bailout would have been bigger, not smaller. The only substantive difference is that it would have gone to these firms directly, rather than being laundered through AIG.
- More generally, this points to a continuing defect with the Treasury analysis, and most other analyses of regulatory changes: the equilibrium responses to these changes. It is clear that Treasury, and Washignton generally, now views OTC derivatives as the financial equivalent of Satan, and wants to crack down on them. Let’s say this happens, and OTC derivatives shrink, or even disappear. How will market participants respond? Will there be less hedging because an instrument that revealed preference suggests is superior to available alternatives is constrained? If so, will the system become more susceptible to disruption, not less? By focusing on the seen, and failing to inquire at all about the endogenous, equilibrium effects of changes in regulation that are largely unseen, regulators are likely to make things worse, not better.
- As I’ve noted before, “standardization” is a red herring in many respects. Standardized instruments may be unsuitable for clearing due to serious information problems.
Other policy recommendations also float in the air, untethered by logic or evidence. For instance, the White Paper asserts in a decidedly conclusory way that “[m]arket efficiency and price transparency should be improved in derivatives markets by requiring the clearing of standardized products . . . and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic execution systems . . . . Furthermore, regulated financial institutions should be encouraged to make greater use of regulated exchange traded derivatives.”
Note the implicit assumption that incumbent arrangements are inefficient, and result in an inefficient level of price transparency. Why should inefficient market arrangements persist? Surely, they can. And if they do, it should be possible to present argument and evidence demonstrating this. No luck if you are looking for anything about that in the White Paper, or virtually any government discussion of this issue.
Another lighter-than-air argument relates to “market integrity”: “Market integrity concerns should be addressed by making whatever amendments to the CEA and the securities laws that are necessary to ensure that the CFTC and the SEC . . . have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives” (p. 46). What the necessary laws might be, the Paper doesn’t bother to say: I guess that’s the mind reading portion of the act. Again, you would think that if there are demonstrable gaps in the existing authorities to punish manipulation, etc., it would be possible to cite chapter and verse to support the claim. No such citations here.
I can only hope–and I am sure that it is just that–that the level of analysis is superior in the remainder of the White Paper. All I can say is that the case laid out regarding the dangers of OTC derivatives, and the improvements that would result from the policy recommendations, is completely lacking. Completely. Like I said above, the policy recommendations regarding OTC derivatives levitate, unsupported by any serious analysis or evidence. Out of such sloppy group-think legislative and regulatory disasters are made. So get ready for an explosion when the spark of reality ignites the gas holding aloft this regulatory Hindenberg.