The regulation of derivatives

by on September 22, 2008 at 6:14 am in Economics | Permalink

Be wary when you hear talk of "derivatives" without further qualification.  They fall into three quite distinct categories: exchange-traded, over the counter (OTC), and swaps.  Here is the best overall paper I know on that division.  Wikipedia is useful as well.

I’ll cover swaps in a separate post soon, so for now let’s set those aside.

Exchange-traded derivatives include the instruments traded at the Chicago Mercantile Exchange and The New York Stock Exchange.  Their regulation has overall gone well and no one serious has alleged that they are responsible for our current financial problems.  That said, a single regulator is preferable to our current dual SEC-CFTC structure.

Most but not all OTC derivatives are interest rate derivatives.  Equity derivatives fit this category as well and so do credit default swaps (even though they are called "swaps" they do not here fit into the swaps category). 

These instruments are OTC because no clearinghouse in the middle guarantees the deal.  That means more credit risk and that no single middleman is tracking net positions on a more or less real time basis.  Ideally we would like to make OTC derivatives more like exchange-traded derivatives and we should consider regulation toward that end.  (Do note that private swaps regulators have already done quite a bit to
clear up the issue of hanging and unconfirmed transactions.)  At the margin the social benefits of such homogenization are higher than what the private swaps regulators will bring on their own accord.  In essence homogenization and trading through a clearinghouse limits the leverage issue to a single, easily-regulated institution and therefore it limits the problem of counterparty risk.

The cost of such additional regulation will be higher transactions costs for the trades themselves and also greater contract homogeneity, which is a requirement for exchange trading, netting, and clearing.  We need to make this move wisely and carefully, otherwise OTC derivatives could move to even wilder and less well regulated markets.  Simply trying to shut down the OTC markets, even if that were the economically ideal vision (unlikely), would in terms of risk prove counterproductive.  But the strong market positions of New York and London do make some effective regulatory action possible for OTC derivatives, especially if done in concert.

The lack of sufficient offset and netting and the inefficient spread of counterparty risk across a large number of institutions is an important issue behind current crises and it does not receive enough attention in most blogosphere discussions.

How about Europe?  The 2006 Markets in Financial Instruments Directive extends traditional European financial regulation to OTC derivatives.  Here is one source: "MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives."  Here is one overview of MiFID

Implementation and enforcement is on a country-by-country basis and of course the UK is the big player.  Read pp.27-29 in the very first link above and you’ll see that overall the UK has a looser regulatory approach than does the United States, though not on every single matter.  For instance the UK is stricter on regulating hedge funds in OTC derivatives markets.

The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises.  Rather countries regulate their financial institutions, their risk, their leverage, and their accounting directly, of course with more or less success.  Regulating the derivatives market, as opposed to regulating the institutions, and their possible participation in those markets, simply isn’t a very effective instrument.

To sum up: a) we should regulate OTC derivatives more, b) those regulations should aim toward establishing netting and well-capitalized clearinghouses, not micro-management of those markets, which would prove both impossible and counterproductive, and c) regulating OTC derivatives is only a weak substitute for regulating the institutions which trade in them.

The U.S. passed the Commodity Futures Modernization Act of 2000, which, among other things, limited the ability of the federal government to regulate OTC derivatives.  I’ll cover that Act in a separate post and yes I do think it should be amended.  But I’ll start by saying that most blogosphere critics of the act simply do not know or understand much of the above.

1 Henri Tournyol du Clos September 22, 2008 at 7:45 am

Tyler, you do not seem to have even a minimal grasp of the logic at work here. Derivatives rest on a contradiction : they primarily exist because the underlying instruments are untradable, mostly because of regulatory or accounting reasons – yet, for them to be hedgeable, the underlying needs to be not only actively tradable but actively traded. The usual problem is thus not getting margin calls or adequate collateral from market participants, but finding patsies from outside the financial system that will bear the risk without hedging, and all the more so if the underlying is illiquid. Or, in other words, the nucleus is usually safe, whether derivatives are exchange-traded or OTC, but problems arise when external participants accumulate too much risk, like the AIGs of this world, or withdraw funding. So better derivatives primarily means better, more liquid, underlying instruments. Full stop.

2 Henri Tournyol du Clos September 22, 2008 at 8:20 am

OK, let me make it a little more complicated then. Counterparty risk from OTC derivatives INSIDE the market has NOT been a huge issue – never has been, really. ISDA rules are quite straightforward. If a bank goes bust, deals are just canceled and the residual amount is transferred to the legal department. Everyone can live with that. The burden is transferred from the agent (trading floor) to the principal (the shareholders). Risk, in fact, globally goes down.

The problem all along, as it has always been, is a liquidity problem. Because risk cannot be hedged properly by market professionals, it needs to be taken over by a succession of outsiders. If outsiders are not willing to play anymore or go bust, then risk concentrates again inside the market, where it cannot be hedged and goes nuclear.

So derivatives are only as safe as their underlying is liquid and delta-hedgeable. OK?

3 Tyler Cowen September 22, 2008 at 8:55 am

Henri, on your last, that is very similar to what I am saying: regulating the banks and other financial institutions is the main issue, not regulating the derivatives. That said, there is still I think an extra social benefit from clearinghouses and yes that comes at the cost of taxing heterogeneity. You’re right to say that a major issue hasn’t arisen *yet*, that is in part because there have been various (costly) interventions. I’m hardly the only one with a residual worry about derivatives markets and this is not some hypothesis which I simply concocted in my head.

4 nick September 22, 2008 at 10:28 am

What about those OTC products that cannot be standardised into an exchange-traded equivalent? If they could already, then they probably would have been – as the buyer would generally pay a premium for the price transparancy & liquidity that an exchange provides. Yet many market participants currently engage in both exchange-traded &/or OTC instruments.
I believe a simpler approach would be to reduce or remove any positive value attributable to OTC derivatives when banks report their Risk Weighted Assets – whilst also requiring full reporting of derivatives liablities *on* their balance sheet.

5 franko September 22, 2008 at 10:46 am

i have an undergrad elec eng degree and an mba and have worked in wholesale
institutional trading for 14yrs, and while i can understand these posts, i
expect that the layman/politicians would be as likely to understand them as
they would a discussion of various aspects of clutch design for a transmission
in their car – this is part of the mainstreet/wallstreet divide – literacy
and numeracy – unsettling…………

6 Paulson September 22, 2008 at 11:09 am

guys look we all thought free-markets were good, but everyone has to now admit we need the governemnt to get more involved in our lives. Look how bad this expiriment with free markets turned out. We need to finally give the Federal Reserve and some real authority. Exclusive rights to creating infinite money out of thin air is just not enough power.

7 mickslam September 22, 2008 at 11:21 am

“The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises. ”

This is part of the reason why we are spending at least $700B. Derivatives regulation should be a first line of defense. Leveraged products = high risk products. Anytime leverage is allowed, you can lose more than you can pay. In general, any product where you can lose more than you can pay should have some oversight.

8 lxm September 22, 2008 at 12:24 pm

How big did this market become? Here’s business correspondent Bob Moon and host Kai Ryssdal on American Public Media’s Marketplace from back in the spring.

BOB MOON: OK, I’m about to unload some numbers on you here, so I’ll speak slowly so you can follow this.

The value of the entire U.S. Treasuries market: $4.5 trillion.

The value of the entire mortgage market: $7 trillion.

The size of the U.S. stock market: $22 trillion.

OK, you ready?

The size of the credit default swap market last year: $45 trillion.

KAI RYSSDAL: That’s a lot of money, Bob.

As in three times the whole US gross domestic product, Bob. And the truth is that Moon probably underestimated. The unregulated and poorly reported credit default swaps may have actually passed $70 trillion last year, or about $5 trillion more than the GDP of the entire world. http://www.dailykos.com/story/2008/9/21/9322/74248/245/602838

What a wonderful shell game it was.

9 nelsonal September 22, 2008 at 1:06 pm

lxm, but that is mostly due to the situation which makes it cheaper to create an offsetting position rather than go back to the original counterparty and undo the transaction. If you buy something and sell the same thing you’re not exposed to the price change any longer, but if they were contracts you still have 2x the notional value created. The standardized clearinghouse settled contracts everyone else is speaking about, would go a long way to cutting that size down substantially.

10 Chris Janak September 22, 2008 at 5:16 pm

I believe two apparently inconsistent beliefs on this:

1) MBS are worth much less than holders originally thought, but they should still have quite a bit of real value.

2) There is very little liquidity in the MBS market; lot’s of sellers but very few buyers. It’s very difficult if even possible for banks to liquidate their MBS positions right now.

These two don’t really fit. If MBS clearly retain a lot of value, then somebody… healthy banks, hedge funds etc. should be eagerly buying them up. So if number one is right, number two should not be also true. Alternatively, if it really isn’t clear how much value these things have (because we don’t know how much worse the housing market will be, etc.) then maybe number 1) is wrong, which explains number 2).

But maybe there is another possibility. Perhaps there are plenty of buyers, but MBS holders are simply unwilling to lock in the loss at current market clearing prices. Rather then stop the bleeding like a disciplined risk manager, maybe these guys are crossing their fingers, praying for a) miraculous turn around in home prices, or b) some sort of government bailout in which they get cheap financing courtesy of the feds or maybe the feds end up buying MBS at higher prices than the market is willing to buy at. The longer they leave these positions open, the more value is lost if housing prices keep dropping and liquidity keeps drying up. But if the feds pass a huge bail, they’ll look like geniuses for leaving the positions open.

So what I’m saying is that I’d assumed banks weren’t selling MBS because they simply couldn’t. But maybe the truth is that they choose not to. I suppose that is one form of moral hazard, a case of executive incentives not aligning with shareholder interests, or possibly both.

11 Sarah Constantin September 23, 2008 at 7:11 am

Thank you, Tyler and others, for this discussion — it’s much more informative than the usual newspaper/blog fare. I’m a student – can I ask an ignorant question?
I can see how a clearinghouse can provide uniform, standard information about credit, but how does it “cover” counterparty risk? If one party can’t pay its losses, does the clearinghouse step in somehow?

Also (the $20 bill on the sidewalk) why haven’t OTC derivatives already been organized in a more transparent market, if the gains are so big?

12 mickslam September 23, 2008 at 2:05 pm

Sarah,

Re: why haven’t OTC derivatives already been organized in a more transparent market, if the gains are so big?

Because the people who see the gains from having common clearing are different than the people who are gaining from the current situation.

Banks are not one huge business, they are a collection of independent businesses within one company. The swaps and CDS desks make much more money from having the products be less standardized than they would gain from having them standardized and cleared. Doing a swap with a single counterparty gives that counterparty leverage over your future trading. You cannot just trade with anyone to exit the trade, you must trade with your counterparty on the trade to truly exit. This results in higher overall fees for the end user customers – and higher profit for the desks.

13 Anurag October 6, 2008 at 1:41 pm

The otc market is seeing lot of changes and the recent financial crisis has yet again brought the need of revolution in OTC market. I just want to throw the point, will this revolution just lead to merger of exchange and OTC market.

I recently wrote a paper over this.. those who are interested have a look at it here
http://researchunlimited.blogspot.com/

14 CJ November 4, 2008 at 12:07 pm

To put this in layman’s terms (as much as possible anyway), would it be fair to say that a significant reason that these products are not exchange traded (or even centrally cleared) is not only because of the lack of customization typically associated with exchange traded products, but also because of the profitibility resulting from the lack of transparency. In essence, those brokering deals in OTC markets profit from the wide bid ask spread and imperfect distribution of market information (recall econ or finance 101, they always qualify effecient market theories with the assumption of evenly or at least well known pricing information) and therefore resist any transparency that would potentially erode that profit.

One thing I don’t believe that has been mentioned regarding the CCP is its ability to know participants exposure across all markets it is clearing which gives them an advantage in limiting or margining of that participant who could be a greater risk to the market as a whole. In bilateral contracts you probably don’t know the extent of your counterparties exposure, but with a CCP you would expect them to have abilities to monitor this.

Finally, to one of Tyler’s original points re higher costs associated w/ CCP, also to be considered might be the premium being paid by one party or the other as a result of imperfect information (i.e knowing the true market value of the product). Therefore, consider you may have a higher transaction cost w/ CCP but when compared to paying a more accurate valuation resulting from more transparent price discovery, is it indeed more expensive.

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