16
FTfm report – Clearing OTC derivatives
A small step in the right direction
Crisis evasion
Moves to regulate
derivatives have not
addressed all the
inherent risks. Eric
Uhlfelder looks at
some of the issues.
T
he move to regulate
derivatives trading
has been well
received but the devil, and
eventual effectiveness of
reform, will be in the
details that will be years in
the making.
Insurer AIG had more
than $500bn (£321bn,
€384bn) in credit default
swaps on its books in 2007.
In December, as market
conditions worsened,
Joseph Cassano, who had
run the company’s deriva-
tives unit, told investors
these positions would need
to be marked down only
modestly.
The following year, the
US bailed out AIG to the
tune of $182bn.
There was not anything
fundamentally wrong with
derivatives that hedged
against a bond default. But
the creation of credit
default swaps without suffi-
cient capital behind them
revealed just one of many
examples of how exposed
the US economy was to ill-
conceived derivatives. Mak-
ing matters worse was the
huge information gulf
between what underwriters
knew and what buyers did
not know, which prevented
the market from self-
correcting.
The passage of the Dodd-
Frank Wall Street Reform
and Consumer Protection
Act responds to this and the
many other market failures
that brought the US econ-
omy to its knees. Political
rhetoric aside, virtually all
observers believe the act is
a step in the right direction.
The move to shift the
majority of derivative trad-
ing to exchanges and clear-
ing houses will help lower
risk, according to the direc-
tor of public affairs at the
US Commodity Futures
Trading Commission,
which, in concert with the
Securities and Exchange
Commission, will translate
Congressional intent into
practice.
The Dodd-Frank Act
requires prudential regula-
tors to set minimum capital
requirements, while clear-
inghouses require pricing
regularly marked to mar-
ket. Just as important, reg-
ulators will establish stand-
ards of business conduct,
including record keeping
and reporting so regulators
will be able to monitor
transactions.
Calpers, the $205bn California pension fund, has been using collateral support deals for some time
‘Even with
sufficient capital,
this could lead
to dysfunctional,
destructive
market behaviour’
But it is far from certain
whether the necessary
standards needed to imple-
ment these changes will be
enacted. These are the
details that must be worked
out.
Henry Kaufman, an eco-
nomic and financial con-
sultant, believes reliance on
clearing houses will help
enforce key trading require-
ments and mitigate the
potential impact of counter-
party risk.
“This will help us avoid
one source of difficulties
that fuelled the financial
meltdown in 2008,” he says.
But he remains sceptical
that a key fundamental
issue will be addressed.
“The vast majority of the
derivative market is under-
written by five to six major
financial institutions,” says
Mr Kaufman.
He does not believe that
new rules will alter this
fact, leaving in place the
systemic problems of con-
centration and financial
organisations that are too
big to fail.
“It will take years to
effect the new regulations
and the interests of these
institutions will be well rep-
resented in the process,”
warns Mr Kaufman. He
fears one such place of com-
promise will involve propri-
etary trading, where there
can be serious conflicts of
interests.
Mr Kaufman is also con-
cerned that there may be
insufficient transparency to
discern full underwriter
derivative exposure by
scale, sector concentration,
and event exposure.
A chief economist at one
of US’s largest banks
shares this concern in see-
ing the likely continuation
of asymmetric infor-
Henry
Kaufman: ‘It
will take
years to
effect the
new
regulations’
mation. “Not only does this
lead to compromised deci-
sion-making on the buy-
side,” he says, “but directly
contributes to excess
returns when buyers can’t
compare risks and prices.”
He is unsure how regula-
tors will devise new rules
that will address these
issues, and does not believe
that clearing – in this
instance – will make much
of a difference.
There will also be addi-
tional costs related to mar-
gin requirements. Titan
Capital Group, a hedge fund
manager with $400m in
assets, relies largely on
derivatives to execute its
volatility trading strategy.
Russell Abrams, president,
says the market still does
not know how much mar-
gin regulators will
require. But however
much it is, it will
cut into returns.
The current
spike in implied
volatility – espe-
cially involving
equity index
options that go out
10 years and longer
– suggests the
FINANCIAL TIMES MONDAY AUGUST 2 2010
Getty
market is pricing in higher
margin costs, Mr Abrams
says. Nevertheless, he
believes reform will lead to
a reduction in leverage and
help ensure a more stable
financial system.
Even before the financial
crisis hit, Calpers, the
$205bn California pension
fund, had increasingly
relied on collateral support
agreements, which is com-
parable to the use of mar-
gins. Eric Busay, head of
the fund’s foreign exchange
and international fixed
income exposure, explains
Calpers is already moving
in the direction in which
the reforms are heading, so
he thinks the evolving rules
will not materially affect
the way Calpers functions.
Viral Acharya, a profes-
sor at New York Univer-
sity’s Stern Business
School, agrees that
improved transparency pro-
vided through clearing will
enhance the efficiency of
derivatives markets.
But he is concerned how
the government would
intervene if clearing houses
were hit by the same blow
that hit traders several
years ago.
“These structures aren’t
banks and how government
could provide liquidity is
not clear,” says Mr Ach-
arya. The CFTC thinks
clearing inherently provides
the necessary backstop to
protect the system. While
its spokesman admits the
full network is not yet in
place, extensive dealer
membership in these
houses and the extensive
margin that will be
involved in clearing deriva-
tive trades will mutualise
risk, he says.
The CFTC is also optimis-
tic that requiring daily
mark to market pricing –
currently not necessary for
bilateral agreements – will
enhance visibility of condi-
tions, as will consistent
reporting to regulators.
Contrary to Mr Acharya’s
point, he says under
extreme circumstances
clearing houses can get
access to Federal Reserve
capital.
To Jonathan Kanterman,
managing director of Still-
water Capital, a $750m fund
of hedge funds, regulators
must use this moment to
cosmically alter their treat-
ment of CDSs.
“Once and for all they
must recognise these con-
tracts as insurance policies
and require sufficient capi-
tal reserves,” says Mr Kan-
terman.
He points out that the
majority of the $787bn US
bail-out programme actu-
ally went to stabilise CDS
trades. The issue is espe-
cially critical, he says,
when we see underwriting
of swaps that are many
times the size of the under-
lying debt.
“Even with sufficient cap-
ital, this could lead to dys-
functional, destructive mar-
ket behaviour,” Mr Kanter-
man says.
Second, he wants bond
ownership rights to be
affected by the degree of
CDS exposure. “There’s the
potential for a conflict of
interest by debt holders
who could stand to profit
more from bankruptcy than
restructuring,” explains Mr
Kanterman. And he would
like to see limits placed on
the purchase of naked
shorts – default protection
without ownership of the
underlying security. Mr
Kaufman agrees.
Like many regulatory
changes necessary to effect
reform, Mr Kaufman wor-
ries the new rules will not
be able to limit the use of
derivatives for speculative
purposes.
“Use of derivatives in this
way exacerbated the impact
they had in the financial
crisis,” observes Mr
Kaufman, “and going for-
ward, without meaningful
restrictions over the origi-
nation and trading of these
securities, they could again
send serious shock waves
throughout the financial
system when we are hit by
the next seismic event.”