One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones. It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.
For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades. But market participants can respond to this by substituting other forms of leverage. The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim. As another example, making derivatives more expensive means that some will eschew using them to manage risk. Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost. As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk. Since true crises are usually liquidity crises, this is highly disturbing.
European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.
Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.
The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.
“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”
Morris makes some other good points in the article, so I recommend you read the whole thing.
It seems that the Europeans are more sensitive to these concerns than was the case in the US. The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem. Unfortunately, with Frankendodd dismissed such concerns. Methinks that the repentance stage will come soon.