Gary “Jeremiah” Gensler continued his assault against CDS, this time from deep in enemy territory, at Markit’s Outlook for OTC Derivatives Markets Conference. If it were up to Gensler, the OTC Outlook would be terminal.
In the speech, Gensler repeats several of his constant themes, and also adds some more, drafting off the cynical European outrage over sovereign CDS. All of the tired standbys are here, including arguendo ad AIG (don’t leave home without it!) but he also uses the shameless “derivatives used to mask Greece’s budget chicanery” argument.
I see. We’re supposed to trust governments to regulate instruments that governments use to escape commitments they’ve undertaken. What’s next? Robert Downey Jr. for Drug Czar?
Gensler calls for regulation of derivatives dealers including capital and collateral requirements. But siloed regulation of specific instruments makes little sense when these are just one element in the portfolios of complex financial institutions that engage in a wide range of risk taking activities. A holistic approach by banking regulators is called for to ensure that risks are priced properly and consistently across all the instruments in bank portfolios. But that wouldn’t give the CFTC a hand in the game, would it?
The CFTC chair also calls for transparency, arguing for something like the consolidated tape in equity markets. I have no problems with that, having advocated a data hub for energy years ago, and suggesting it for OTC derivatives more broadly more recently.
But Gensler overstates the potential benefits. He laments the fact that during the crisis there were “no reference prices for particular assets.” Well, duh. That’s because they didn’t trade. And mandating that something trade on an exchange will not magically mean that it will trade at all. Low volume instruments typically don’t trade on exchange because it’s not worth the cost of maintaining a market that is seldom used. This isn’t Field of Dreams: just because you build a trading facility, doesn’t mean that people will come to trade everything on it. Even with an exchange mandate and/or post-trade transparency, many instruments will still lack reference prices on a timely basis because there is no underlying demand to trade them with any frequency.
Which undermines Gensler’s next demand: that derivatives be cleared. Sufficient trading activity is a necessary condition for clearing to be the best way of allocating default risk (though not a sufficient condition). In addition, I note, wearily, that Gensler again invokes clearing as a deus ex machina that “guarantees obligations of both parties” and “takes trades off the books of financial institutions.” Pray tell, where does the risk go? Who provides the guarantee? Is there a guarantee fairy? Do leprechauns guarantee trades with a pot of gold at the end of a rainbow? (Or is that needed for the Irish banks?)
In this speech, Gensler expands his criticism of CDS to take up the by now standard “no insurable interest argument” against holding “naked” CDS positions: who knew regulators were such prudes? In a section titled “market manipulation” he regaled his audience with the story of how in the 18th century unscrupulous folk had taken out insurance on ships they didn’t own, which then seemed to have a bad habit of being lost. This, and related schemes, led to the passage of statutes that required the purchaser of insurance to have an insurable interest.
There is an argument to be made for the efficiency of such rules in some contexts. In particular, in the specific historical case Gensler discussed, the probability of detection was probably quite small, given the difficulty of proving that a particular vessel sank as a result of foul play (difficult if for no other reason that it was lying at the bottom of the ocean, perhaps with the bodies of its crew). This meant that ex post deterrence of this conduct was likely very ineffective. Moreover, there is no compelling benefit of A buying insurance on B’s property or life.
The question is whether this analogy is apt for CDS. I think not.
First, there are potentially beneficial reasons for naked CDS. Speculation of this sort can provide valuable information: markets that restrict short sales are typically less informationally efficient than those that don’t, and experimental evidence suggests that short sale restrictions encourage bubbles. Moreover, market makers may sometimes take naked positions in CDS pursuant to their vital role of providing liquidity. In addition, holding naked CDS against related positions (e.g., equity positions in the same firm, CDS positions in other firms in the same industry) can be sensible spread trading strategies that ensure that financial instruments are priced appropriately relative to one another.
Second, it is interesting that Gensler cannot point to any particular example in CDS analogous to what apparently happened to ships in the 18th century. He resorts to the “some say” dodge, stating that “some observers . . . contend” that CDS swap protection buyers “may have engaged in market activity to help undermine an underlying company’s prospects.”
Be a man Gary. If you have evidence of this, let’s hear it. If not, some say you should shut the hell up. I would also note that Gensler’s argument can be applied to pretty much any financial instrument. Owners of puts on a company have an incentive to do thing to undermine that company’s prospects. What makes CDS special?
CFTC anti-manipulation standards require a finding that a manipulator had the ability to cause distorted prices, took actions that had the effect of causing such a distortion, and acted with the specific intent to do so. Is Gensler arguing for a different standard for CDS? Does he have any evidence that most CDS holders, naked or otherwise, have the ability to cause the distortions that Gensler conjectures? Can he cite specific examples of where this ability to cause was actually exercised to cause the mayhem he describes? Most importantly, does he seriously believe that such an action could be undertaken without being detected? This seems an area in which ex post deterrence through enforcement action or private action is best suited, which is quite different from the shipping example that Gensler discusses. Blanket bans against naked CDS don’t make sense in this context, as they preclude potentially valuable uses of this strategy, while (so far only hypothetically) misuses can be deterred efficiently ex post.
Gensler also trots out the empty creditor problem. As I argued here and here, the conventional analysis of this issue (advanced most prominently by Henry Hu, and which Gensler essentially repeats) is seriously incomplete because it fails to address the latent Coase Question of what transactions costs preclude voluntary trades resulting in optimal allocation of rights. Insofar as remedies are concerned, Gensler and I actually agree: he recommends position disclosure and voting in bankruptcy based on economic interest, just as I did last April in the first of the two posts linked above.
The CFTC chair also criticizes the Basel capital rules insofar as they apply to CDS. I yield to no man in my disdain for these rules, and think that they were a major contributor to the financial crisis (to the extent that they incentivized banks to undertake the same trading strategy of holding large positions in AAA CDOs). But I think that Gensler, in his Ahab-like obsession with CDS, focuses on a side issue. Specifically, he criticizes the component of the rules that give capital relief to those who hold CDS as a hedge against other risk exposures. He wants more restrictive capital treatment of CDS -hedged positions. He pejoratively states that this treatment means that “a bank can essentially rent another institution’s credit rating to reduce its required capital.”
Well, yeah. That’s what hedging is all about; an institution is laying off the risk to somebody who bears it at a lower cost. This can be done by selling the underlying instrument, or entering into a hedging transaction utilizing a related instrument. Sometimes–a lot of the time–the latter is more efficient. Economically, it makes perfect sense to require less capital against hedged positions. It would be perverse indeed to do otherwise.
As to specific restrictions, Gensler suggests that “only CDS subject to collateral requirements could be allowed to provide capital relief.” Perhaps he hasn’t read the most recent ISDA Collateral Market Review (released on March 1), which states that 97 percent of CDS positions are collateralized.
And by-the-way: AIG’s CDS contracts were subject to collateral agreements.
So, Gensler’s specific recommendations are red herrings, even in the context of arguendo ad AIG.
Would it that CDS and OTC derivatives were the only object of Gensler’s control fetish, and desire to swell the authority of the CFTC. But no. Not only are there position limits, but Gensler has also set his sights on the market for power firm transmission rights, setting off a turf war with FERC.
Gensler is attempting to put Rahm Emanuel’s “let no good crisis go to waste” dictum into action, exploiting the financial crisis–and importantly, more than twice told tales about the financial crisis–to advance a regulatory agenda that would concentrate tremendous power in his agency. This agenda is built on fundamentally flawed analysis. What’s more, the agency that he heads quite clearly has not demonstrated that it has the capability, resources, or expertise to exercise those powers effectively and judiciously. And I am being very charitable in saying that. (If you have any doubts, take some time and look through the reports the GAO has written about the CFTC over the years. It does not make for happy reading.)
I have some novel suggestions, Chairman Gensler. First, do no harm. Second, be circumspect about anyone’s abilities–including yours–to micromanage huge, complex markets.