Just How Will That Work, Exactly?
In his testimony in a joint hearing of the House Financial Services and Agriculture Committees last week, Treasury Secretary Timothy Geithner stated:
We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.
Just how is this “careful policing” supposed to work? Will those who want to enter into customized transactions have to get pre-approval? This seems inherently unworkable, due to fact that transactions are frequently time sensitive. Alternatively, will parties have the ability to enter into transactions without prior restraint, but face the risk that a regulator will subsequently challenge, and disallow the transaction?
Under either alternative, what are the criteria that will be used to separate the unspurious sheep from the spurious goats? Given the myriad possible reasons for entering into a particular transaction, and designing it in a particular way, it seems nigh on to impossible to identify ex ante a set of criteria that can be employed. Hence regulators will have incredible discretionary powers. Presumably there will be legal challenges to regulator decisions, meaning that there will be more than a few court cases arising out of these “policing” efforts.
The closest analogy that comes to mind is the IRS, which rules on the permissibility and legality of various financial transactions that have tax implications. We all know the byzantine and costly process associated with such powers. In essence, the CFTC and/or SEC would have to be empowered to make similar judgments of the commercial rationale for particular transactions, and evaluate the trade-offs that market participants make. For instance, is a particular transactions structure designed to reduce basis risk, or to escape the clearing requirement? What will be the standard applied to such evaluations? Who will have the burden of proof?
Given the myriad arcane and complex commercial rationales that may exist for entering into derivatives transactions, especially customized ones, it stretches credulity to the breaking point to believe that the SEC or the CFTC have the expertise, not to say the incentive, to make the right call. There will be many false positives and false negatives. What’s more, the transactions costs of such a system are likely to be large, just as is the case with the tax code. Much money will be spent in court trying to reverse the false positives and false negatives.
Am I done? Hardly. Let’s consider the regime in which done deals are subsequent to regulatory challenge ex post. What happens if a particular transaction is found to be “spurious”? The deal will be in the money to one party or the other. How is it to be unwound? Is it just terminated, costing the in the money party the value of the contract, and allowing the loser to skate? Is there some termination process whereby the contract is valued? But if the deal is customized, who does the valuation? Another source of litigation. Just what we need.
Relatedly, there is the possibility that the underwater party to a contract can opportunistically utilize the requirement that a deal not be “spuriously” customized to attempt to escape the onerous obligation to perform. In the old days, transactors who entered into futures contracts tried to argue that (a) they entered into the futures as a speculative wager, and (b) wagers are uneforceable in court, to escape losing trades. I foresee such attempts as inevitable if “spurious” customization is banned. Thus, such a ban will undermine the reliability of contracts and create legal risks. This is hardly a desirable public policy outcome.
All in all, attempts to distinguish spurious from non-spurious customized transactions, and the Talmudic inquiries necessary to do so, will be extremely onerous. Moreover, the existence of such a distinction creates substantial legal risk, and the prospect for protracted and expensive litigation. But perhaps for Geithner et al, these are features, not bugs: regulatory burdens that will serve the larger purpose of suffocating the OTC market.
And all this begs the question: Why would anyone want to create a “spuriously” customized contract? One can understand why one would want to structure a deal solely to reduce tax payments, hence the arms race between the IRS and financial engineers. It is far harder to understand why someone would want to customize something to escape the obligation of having it cleared, or traded on an exchange. It is easy to understand why someone would want to customize a deal to achieve specific risk management objectives that cannot be attained using standardized and cleared contracts. But what’s so bad about clearing that people would want to go to the lengths of designing a customized, illiquid instrument solely to avoid it? And if the private “bad” of clearing is so big, where’s the public “good” that offsets it?
This puzzle as to why consenting adults would choose to customize to avoid clearing and exchange or exchange-like clearing is just part of a larger puzzle: if the OTC market is so terrible, why do informed parties utilize it, and why has it grown relative to the exchange traded sector to such an extent that OTC volume and open interest now dwarf exchange volume and open interest? The entire thrust of the Geithner-Obama policy implicitly assumes the existence of what would have to be the greatest market failure in the history of man, a market failure that has led to trillions and trillions of dollars of transactions that are suboptimal in the way that they are designed, traded, cleared, or settled, or all of the above. So just what is the market failure? So far, the administration and its cheerleaders in the media have failed miserably to identify it, let alone to show that its cost is sufficiently massive to justify a vast re-engineering of the financial markets. Repeating “AIG AIG AIG” over and over again like financial Hare Krishnas doesn’t cut it.
