Compare and Contrast
The UK’s Financial Services Authority (FSA) released a report on OTC derivatives market reforms in December. In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments. It recognizes the trade-offs involved. It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates. It recognizes the burdens of mandated clearing and the associated cash flow risks on end users. It advocates an increased reliance on data repositories (something I advocated in late-2008 for OTC derivatives, and for energy years before that). It identifies counterparty risk management as the key issue, and concludes that mandated exchange trading is unnecessary to address this issue, and an unwarranted attempt to impose market structures.
Its analysis of position limits is especially good. I liked this part:
The second limb of the Commission’s proposal is to give regulators the possibility of setting position limits to counter concentrations of speculative positions. Such an approach would go beyond the existing legislative remit in the UK and more importantly we have not seen evidence which supports such an approach. The UK regime applies its position management tools to all participants, without a specific emphasis on those that do not have a desire to hedge physical positions, or take physical delivery. We do not consider activity by financial participants to be de facto manipulative. We do not therefore consider that there should necessarily be a distinction made between “large speculative” and “large non-speculative” positions for the purposes of combating manipulation – the focus should be on combating “large positions that lead to manipulation” irrespective of whether they are held by financial participants or not.
And this:
9.20 Over the last two years, certain commentators and market observers have linked the growth in financial, or “speculative”, participation in commodity markets with recent significant price movements, particularly in oil.We recognise that this type of investor has impacted the nature of commodities markets as a whole, for example, as a result of different methods of trading and increased volumes.
9.21 However, the majority of academic studies and evidence do not support the proposition that prices have been systematically driven by this increased inflow of financial interest. Indeed the majority of commentators have concluded that commodity price movements cannot be solely attributed to the activities of any one class of investor and are principally attributable to market wide factors.We agree with these conclusions.
Proposals for combating price movements
9.22 The FSA’s regulatory aim (as defined by legislation) is on maintaining fair and orderly markets, not limiting price movements or volatility. In any event, we do not believe a case has been made which demonstrates that prices of commodities, or other financial derivatives, can be effectively controlled through the mandatory operation of regulatory tools such as position limits, whether on exchange or OTC. Analysis of market data where position limits are already in use suggests that this has not shown a reduction in volatility or absolute price movements compared to contracts where they are not.
9.23 We also consider that limiting financial participation more generally would hamper market efficiency. To use oil markets as an example, increased participation has brought significant benefits, such as greater depth and liquidity.
In contrast, on this side of the water, from the Chairman of the FSA’s US counterpart, the CFTC, we get drivel like this. He’s said it all before. Arguendo ad AIG. Horror stories about interconnections. Completely misleading conclusions based on outrageously inappropriate analogies between impossible to price toxic assets like MBS-based CDOs and vanilla swaps. Assertions that end-users don’t know their own economic interests, and subject themselves to the predations of a “small group of derivative dealers.” (His comparison between buying an apple and the OTC derivatives market is especially idiotic.) Wildly misleading insinuations that clearing will reduce interconnections in the financial system. Similarly wildly misleading insinuations that OTC trades are not collateralized. (Before anybody says this about AIG again, read the AIG Special Inspector General’s report. Please.) Egregiously misleading insinuations that failure of a clearing member “does not harm its counterparties.” (Then, pray tell, who eats the loss? The derivatives fairy?)
Ugh. What inanity awaits us when CFTC announces its position limit changes?
Overall, the Europeans are quite dismayed at the trajectory of regulatory and legislative initiatives here in the US. This dismay is documented in a couple of articles by Jeremy Grant in the FT. This quote is priceless:
Richard Raeburn, EACT chairman, said companies were looking for a “clear carve-out” from the clearing and exchange-trading requirements.
“My fear is that what happens in the US will pre-empt the ability to be sensible over here,” he told the Financial Times.
Yes, Mr. Raeburn, be afraid. Be very afraid.
If legislators want to mandate something, they should mandate reporting of data to data repositories. The more information that is available to market participants, the greater the ability for them to determine risk. The greater the ability to determine risk, the greater the ability to price that risk.
Comment by Charles — January 7, 2010 @ 1:44 pm
Agreed, Charles. I’ve been advocating that for CDS and other OTC derivatives since last fall, and for energy before that.
Comment by The Professor — January 7, 2010 @ 6:06 pm
Some of the remarks made by Gensler are absolutely jaw-droppingly naive.
“the constant has been that it is still dealer-dominated” – that’s right; it’s called “liquidity provision”, and if there were no “dealers”, there’d be no market and a lot more risk.
“The price is not discovered on transparent trading venues, such as exchanges” So what? Some is, and the rest is discovered elsewhere. He seems confused between the function of market *providers* and market *reporters*.
“Over-the-counter derivatives are traded out of sight of federal regulators and out of sight of market participants.” What?
“The public learned a new term – “toxic assets” – assets held by banks that were too difficult to price.” Category mistake between “toxic” and “illiquid”.
A *toxic* asset is one that’s patently worthless, or worse. An *illiquid* asset is one that’s hard to buy or sell easily at its market worth, because its worth is unclear.
A book of NINJA mortgages is a *toxic* asset because the NINJAs patently can’t pay. The trailers the NINJAs’ loans are secured on are *illiquid* assets. They’re worth something, maybe between $5,000 and $8,000 apiece (or whatever), but if you absolutely have to trade 1,000 of them today, you may receive $4,000 for one or you may have to pay $10,000 for one.
A toxic asset would tend to be illiquid, but only because who’d want it? The terms aren’t synonymous.
“A greater number of market makers also lowers risk to the system and provides greater liquidity”. Really? What if the smaller books that would result provided fewer self-hedging offset trades? Then there’d be more risk per player and probably fewer market makers.
“How would you know if you got a fair price if you didn’t know how much the last person paid for the same apple?” Well, you could look at other apple vendors’ offered prices first, then ask the supermarket for theirs, and if the price they then disclose is competitive, buy their apples. I agree it would be tough if everybody refused to disclose their price for apples, but this has never happened (apart from anything else, disclosing the price makes invoicing soooo much easier).
“Clearinghouses act as a middleman…They require derivatives dealers to post collateral so that if one party fails, its failure does not harm its counterparties…It is essential that we reduce this risk in the system.” If one party fails, clearing houses distribute the $$ impact immediately to their members. A collapse on an AIG scale would simply have blown up all the clearing houses instead of the taxpayer.
Comment by Martin — January 8, 2010 @ 9:07 am
Martin–Thank God somebody gets it. Sometimes I feel like I’m shouting down a well. If anything, you are too kind by writing off Gensler’s remarks to naivete. But your inventory of the inanities in his speech is spot on. Your statement about the impact of a CH failure is particularly important. This whole idea pushed by Gensler (and Geithner and too many others) that somehow a failure of a clearing member has no financial impact on other firms is so idiotic that it’s beyond belief. I don’t know which would be worse: they don’t know it’s idiotic, or they do, and are just lying through their teeth. You are particularly correct about the effect of an AIG-magnitude failure in a cleared market. I wrote about that last March in a couple of posts, most notably “It’s A Wonderful Life: The AIG Edition.”
Thanks for your comment.
Another possibility is that he knows his views are idiotic, but he still wants to over-regulate derivatives anyway.
There is a cast of mind that thinks an economy has to “make things”, meaning only tangible things, or there’s something wrong with it.
I’ve never understood why a $ of forex earned from selling derivatives is worth less than a $ of forex earned from selling T-shirts.
Comment by Martin — January 8, 2010 @ 3:22 pm
Martin–Thomas Sowell (in Knowledge and Decisions) calls this the “physical fallacy.”
Yeah, maybe Gensler is like that old joke: He wants to regulate derivatives in the worst way, and he has.