Streetwise Professor

April 20, 2012

This Goldilocks Goes With “Too Small”

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 2:48 pm

The CFTC had to play Goldilocks and decide the level of OTC swaps activity required to make a firm a swap dealer and thereby subject to the collateral and capital requirements and other obligations entailed in such a designation.  Earlier proposals ($100 million, then $3 billion) were commonly deemed too small.  Industry proposals were deemed to be too big.  The Commission decided on $8 billion, with the possibility of reverting to $3 billion depending on the results of forthcoming data collection and analysis by the Commission.

The usual suspects-like “Better Markets”-claim that the limit is far too big, and represents a huge loophole.  Genlser (no Goldilocks, if you know what I mean) fired back, claiming that the limit was actually quite small, compared to the immense size ($300 trillion notional) in the US swaps market.

These kinds of debates are frustrating in any event, because cutoffs like this economize on information, but are inherently arbitrary.  They focus on the easily measured, rather than the economically significant.  They reduce multi-dimensional problems to a single dimension, which inevitably leads to distortions.  In particular, they provide incentives to devise transactions and structure business to circumvent the rule.

The real questions that should be asked in determining the criteria for swap dealer designation are: What is the market failure that this regulation is intended to address? and What criteria will mitigate that market failure in a cost-effective way?

The whole justification for Frankendodd is that derivatives pose a systemic risk.  Systemic risk, properly understood, involves some sort of externality.  One potential externality is that a default by one large derivatives trading firm can lead to a daisy chain of defaults.  Another is that default costs are passed onto taxpayers in the form of bailouts.  Swap dealer designation, and the consequent regulation of their activities, are supposedly intended to address these externality problems.

Viewed from this perspective, $8 billion in notional amount seems like a very small number.  Based on BIS numbers, market values are about 3 percent of notional amounts.  Applying this to an $8 billion notional gives a market value of $240 million.  The financial system can withstand such a default, and even several such defaults.  Yes, counterparty risk also depends on gross amounts, but even an $8 billion loss is not catastrophic, especially inasmuch as any such loss would be spread over a number of counterparties.

To put things in perspective, look at the notional holdings of firms whose collapse or threatened collapse arguably posed a systemic threat.  LTCM’s derivatives book was $1.25 trillion-in 1998.  That’s 2 orders of magnitude bigger than the $8 billion figure being imposed 14 years later, when the markets are substantially larger.  Lehman’s was about $35 trillion-over 4000 times the  $8 billion threshold.  Bear Stearns: $13.5 trillion, about 1700 times the $8 billion. AIG’s notional was down to $1.6 trillion-200 times the threshold-at the time of its default.   And note that Lehman and AIG failed nearly simultaneously.

I am unaware of any default by a firm with $8 billion notional that created a systemic risk.

So I am in the too small camp.  I don’t know exactly what the number is, but there should be a pretty close correspondence between firms that are deemed to be systemically important and those that are subject to the requirements imposed on swap dealers.

Yes, the default of a firm with $8 or $10 billion in notional would presumably be painful for its counterparties.  But absent any knock-on effects, any externalities, that loss is internalized by the contracting parties.  This does not require any regulation to protect them.  Let them protect themselves, contract as they will, and live with the consequences.

I should also note that swap dealer regulation, which is effectively microprudential in focus, and which attempts to regulate only a part of firms’ capital structure, will not have the desired effects on systemic risk even if it is applied only to systemically important firms.  As I’ve noted repeatedly, firms can contract around this restriction, and will substitute different forms of leverage-and potentially riskier and more fragile forms of leverage-for the leverage squeezed out of derivatives transactions through collateral requirements.

In sum, all this to-ing and fro-ing over the swap dealer rules has resulted in a regulation that is far more inclusive than necessary to achieve its ostensible purpose of reducing systemic risk.  Moreover, the whole idea is fundamentally flawed for a reason I’ve written about often: it is virtually impossible to reduce the risk in the financial system by regulation of the pieces.

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1 Comment »

  1. I think what we are seeing is the regulatory mind at work. A former friend of mine was once criticized at the FDIC for seeing the big picture – what he was supposed to do was tick the right box. Setting a “low cap” (whatever that might mean) is a bit of ass covering, and provides a number that can be easily ticked off on a reg report even though a notional cap is, as you note, inherently flawed because a firm as a whole can contract around it. IN THEORY, the firewall will protect the inter-party market from such contagion, but the fact of the matter is that it does so only at the cost of other participants and at the honesty of the members when they are under pressure(MF, anyone?).

    There is an even bigger flaw with any notional amount. A notional amount is not a measure of risk. Two books:

    1. A balanced book net long 0 in 30 day to one year Treasury swaps (4mmm long and short)
    2. Long 8mmm synthetic 20 year Zero total return).

    I don’t think these are the same.

    The counter argument is that using VAR and other measures will take care of this. If so, why have a cap? Secondly analytics are easily manipulated to get around restrictions and are subject to “externalities”. For example a Loan SIV was modeled using a Markov process volatility state stochastic model and rated. Based on historical performance of the assets over the last four years (not their prices) it could have survived the meltdown of the ABCP market very, very well and made a great deal of money for the capital holders. The problem was that no one buying CP believed anything – the liquidity buffers, the model results, etc., so it folded at the height of the crisis. Those pesky humans, again, being fearful and not trusting their betters!

    Comment by sotos — April 20, 2012 @ 4:30 pm

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