Streetwise Professor

Senator Thomas Harkin (D-for-don’t even need to ask, IA) has introduced legislation that would require all derivatives trading activity to take place on a futures exchange regulated by the CFTC.

That’s a really dumb idea, even from a senator.

The rationale for this move is somewhat inscrutable.   Harkin said:

The economic downturn in this country is forcing us to examine all contributing factors on our markets.   With the value of swaps at a high of some $531 trillion for the middle of this year — 8 1/2 times the world GDP [gross domestic product] of $62 trillion — it is long past time for accountability in the markets.

Can you say non sequitur?   I knew you could.

The Solon of the Sow Belt continued:

By regulating all futures contracts, the Derivatives Trading Integrity Act restores confidence in the markets and provides the soundness and integrity the financial system needs

And just how does it do that?   Does your assertion make it true, Senator?

Market participants and the instruments they trade are heterogeneous.   This heterogeneity can–and almost certainly does–make it efficient for multiple, differentiated trading platforms to exist side-by-side.   Heck, even the most homogeneous of financial instruments–the stock in a particular company–trade on different types of trading mechanisms in order to meet the diverse needs and preferences of investors with different information and preferences regarding the rapidity with which they want to trade.   Closely related instruments can trade on a variety of platforms.   For instance, cash Treasuries and Treasury futures trade using very different mechanisms.   In a nutshell, it is desirable to allow the development of a variety of different trading mechanisms (microstructures) to permit a discriminating match between the characteristics of the mechanism and the characteristics of the instruments and their traders.

Forcing a one-size-fits-all trading approach completely ignores this heterogeneity.     It will impose costs on market users, and may even serve to undermine their soundness and integrity.

I’ve argued repeatedly that with respect to clearing (i.e., default risk sharing) in particular, there is a strong case to be made that some instruments should be centrally cleared–but some should not.   Central clearing provides benefits, but it comes with costs due to asymmetric information.   Indeed, since market participants internalize most of the benefits from clearing, they have a strong incentive to adopt it unless there are even larger costs.

With respect to the soundness of the financial system, forcing central clearing can increase systemic risk.   Clearinghouses don’t price dealer balance sheet risk–dealer counterparties in bilateral OTC markets do.   Dealers typically have better information about the creditworthiness of their counterparties than a clearinghouse will.   Thus, they can price default risk more accurately.   Clearinghouses treat all members as if they are the same–even though they are not, having different balance sheet risks, for instance.   This equal treatment of the unequal tends to divert trading activity towards riskier firms more likely to default.   Reductions in collateralization reduce trading costs and encourage an expansion of trading activity.   At best, clearing redistributes the default losses, and this redistribution (away from derivatives counterparties to dealers’ other creditors) can exacerbate, rather than reduce systemic risks.

Market participants recognize all of these effects.   They imply that there are costs to central clearing, and the fact that OTC market participants have not adopted clearing for many derivative products is strong evidence that these costs exceed the benefits that clearing would provide them.   They certainly know more than a certain senator from Iowa.

There is a case to be made for creating a centralized database of derivatives trades.   This can be done, however, without forcing everything onto exchanges, or requiring clearing.

There is also zero evidence that the current financial problems were in any way caused by OTC derivatives trading.   Of all the implosions of financial firms, only AIG’s was directly attributable to derivatives trading.   Moreover, the much feared knock-on effects from the failure of a big derivatives dealer have yet to materialize, and won’t in my view.   The biggest problems in the financial system are attributable to securitization, and the collapse of real estate prices.   These, in turn, are traceable to a variety of sources (e.g., the Fed, lax banks)–none of which are the OTC derivatives market.   So, when bloviating about “contributing factors,” it would be worthwhile for the senator to take a serious look at what those contributing factors actually are, rather than reflexively blaming derivatives.   His criticism echoes the common descripton of derivatives as “financial weapons of mass destruction.”   (And, by the way, (a) if I hear or read that expression one more time as a QED-end-of-argument-substitute-for-analysis, I just may go postal, and (b) if Warren Buffet is so smart and has avoided taking undue risks, why has the CDS spread on Berkshire Hathaway blown out?)   The substitution of conventional wisdom for serious thought is intellectually lazy, and a recipe for policy failure.

The funny thing (in the laugh-to-keep-from-crying sense) about Harkin’s proposal is that it harkens (I’m so punny) back to Congress’s first regulations of derivatives markets in 1921-1922.   At that time, Congress required all grain futures to be traded on a “contract market”–i.e., an exchange–registered with and approved by the government (USDA at that time, later the CEA and still   later the CFTC.)   So, rather than come up with something new, Harkin resurrects an approach first trotted out when Ford was actually a vibrant concern–and Henry Ford I was running it.   I thought we were in the era of change–silly me.

That approach caused no end of problems as the pace of financial innovation picked up in the 1970s and 1980s, as it became increasingly clear that not everything SHOULD be traded on an exchange.   This led to a sequence of Rube Goldberg-esque attempts to reconcile the irreconcilable–the exchange trading requirement and the fact that not everything was most efficiently traded on exchanges. The passage of the much (and wrongly) maligned Commodity Futures Modernization Act eliminated the confusion and legal risk that the old approach had created.

In brief, forcing a one-size-fits-all approach is doomed to failure because it fails to take into account the heterogeneity of financial instruments and financial market participants.   We have the proof of experience that it is doomed to failure.   But nonetheless, Harkin is playing King Canute, trying to force markets to conform to his will.   Good luck with that.   All it will do is create opportunities for lawyers–and undermine the efficiency and arguably the soundness of our financial markets.

I am sure that it is just coincidence that Harkin is Chairman of the Senate Ag Committee, which has jurisdiction over the CFTC–which, under Harkin’s bill, would have regulatory authority over every derivative traded from sea to shining sea.   Think of the campaign contributions!   The thought never crossed his mind, I’m sure.

Like Lily Tomlin said, we try to be cynical, but it’s hard to keep up.