Regulating Derivatives : The Case for Incentives

Increased regulation of derivatives is coming. At least that was the consensus view of the participants at a recent breakfast discussion I attended “Regulating Derivatives in the Wake of the Financial Crisis”, hosted by FinReg21. The discussion was lead by former SEC Commissioner, Edward H. Fleischman who is currently the Chair of the International Securities Regulation Committee of the International Law Association, and Professor Stephen Figlewski, Professor of Finance at the NYU Stern School of Business and editor of the Journal of Derivatives. The participants included a representative cross cut of the legal and business communities involved in these instruments.

This isn’t a surprising conclusion given there are submitted bills and bills in formation in Congress and a Treasury plan on the table. Although there is overlap in the provisions of these competing plans there are some significant differences in several key provisions. In no particular order here goes my take on the key issues in this discussion.

1. Derivatives should only be used for hedging purposes. Translated that means derivative trading will end at least in this country. If only hedging is permitted then every hedger will be put in the difficult position of finding another hedger with the opposite exposure. Speculators serve a real economic purpose in providing liquidity and making markets more efficient. There are plenty of orderly, stable markets rife with speculators. Take the cash market for U.S. Government bonds, or futures for example, which gets me to point 2.
2. Most if not all derivatives should be exchange traded. This is one way of addressing the transparency issue. Exchange traded instruments are transparent and OTC derivatives for the most part are not. Therefore, requiring OTC derivatives to be exchange traded will make them transparent. Logical but impractical. The popularity of OTC derivatives is at least in part due to the market’s capacity to tailor instruments to reflect precise risk exposures. Tailored instruments do not succeed on exchanges because the number of participants interested in trading the same tailored exposure is likely to be quite small; certainly not enough to justify an exchange listing. Therefore some exclusion has to made for tailored derivatives; however implementing that exclusion is not so easy as will be discussed below.
3. Derivates should be cleared by a centralized facility (or facilities). This is a solid idea. Besides promoting transparency central clearing reduces counterparty risk assuming of course that the clearing agents are sufficiently well capitalized to actually guarantee the trades they settle. Confidence in the financial cushion provided by centralized clearing would benefit from having more than one agent; how many is optimal is a discussion for another time.
4. Derivatives should be standardized (at least as much as is practical). Standardization facilitates exchange trading, but since exchange trading is really not necessary for greater transparency and is not a realistic objective for the entire market, who cares. Standardization would also clearly facilitate central clearing and about this I do care. Although a non standard instrument could be centrally cleared it does not follow that all centrally cleared instruments could be non-standard. It would likely place too great a burden on the clearing agents.
5. Given that there is benefit to standardization how would it be implemented or enforced? Would teams of attorneys lay out in precise detail the terms and conditions of each standardized derivative? And even if they did how long would it take to re-engineer standardized derivatives and make them non-standard? Why you might ask would anyone favor non-standardized derivatives? See 6.
6. The answer is money. Opaque markets are more profitable than transparent markets, and therefore dealers will have a bias against transparency. Many recent innovations in fixed income markets are in part explainable as an ongoing march to create the next successful opaque, and highly profitable, market. OTC derivatives are a relatively recent manifestation of that motivation. There are OTC derivatives currently traded that appear to generate sufficient volume to support being exchange traded but there has been no groundswell of support from dealers to list them. Although I am not in favor of exchange trading requirements as discussed above centralized clearing, which I do favor, will also benefit from standardization. The question then is how to promote centralized clearing?
7. I prefer incentives to mandates. Capital requirements can be used to encourage market participants to favor clearing their derivative trades in a centralized facility. Make it more expensive to keep trades away from such facilities by specifying greater required capital for OTC derivatives that are not centrally cleared. Then dealers are incented to make their trades conform to standards required by a centralized clearing agent. Only when the cost of clearing is so great that it approaches the magnitude of the capital charge would a dealer be inclined to favor clearing direct rather than central clearing. That situation is likely to occur for those derivatives that must be tailored to work and are sufficiently different so that clearing is made complex. Further the cost of direct clearing would have to be significantly lower to compensate for the difference in capital requirements.
8. Centralized clearing is not my idea. It has floated through a number of proposals including the one authored by the administration. Academics and analysts have also gotten behind the idea. The hard part is how to set the differential capital requirements. Set them too high and the idea is a non-starter. Set them too low and there is no incentive to move to central clearing. Finding the Goldilocks levels for capital requirements is complex and possibly even intractable. Some regulatory authority cajoling in additional to capital requirements may be needed to ensure success. Regardless, the more we can rely on objective capital requirements that provide incentives to encourage centralized clearing for the vast majority of, if not all, derivatives so much the better.

Ben Wolkowitz Headstrong September 27, 2009