This briefing paper provides background on the derivatives markets and their role in the financial crisis, evaluates aspects of the main reform proposals and whether or not these reforms should be implemented. One of the least understood but potentially among the more damaging factors contributing to the crisis in global financial markets is an asset class known as over-the-counter (“OTC”) derivatives and one OTC product in particular known as credit default swaps or “CDS.” Indeed, even were there not multiple financial market crises underway, reforming the CDS market would still be an urgent problem. Warren Buffett famously described CDSs as “weapons of financial mass destruction” in Berkshire Hathaway’s 2002 annual report.
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However, Buffett recently admitted that his company has sold at least 251 derivative contracts with a total face value of more than $14 billion. Buffett says he plans to continue selling CDSs because “the odds strongly favor making money.” The architecture of derivatives markets is now in play because of two, related policy concerns that arose from the financial crisis: systemic risk and market efficiency. Systemic risk is the danger that failing financial institutions will destabilize the financial system and thereby threaten the wider economy. When unconstrained by effective risk management or regulation, derivatives enable high concentrations of risk in individual financial institutions. Derivatives markets are efficient if trading costs are low and risk is well distributed among investors. The most important ingredient for market efficiency is competition, which in turn depends on price transparency and on relatively unencumbered access to trading by a broad set of market participants.
The financial crisis was exacerbated by derivatives markets in two basic ways. First, insurance companies such as AIG, Ambac, and MBIA used CDS to sell protection on CDOs backed by sub-prime mortgages to such an extent that they were severely impaired when those CDOs experienced large losses from mortgage defaults. This in turn contributed to the weaknesses of the banks that had bought and relied upon the protection of these credit default swaps. Second, the failures of the large investment banks Bear Stearns and Lehman Brothers were exacerbated by a run of their OTC derivatives counterparties. The flight of these derivatives counterparties, as they sought new positions with other dealers, may also have contributed to the fragility of global financial markets. In the same vein, a number of other large dealer banks had to be bailed out for reasons that included the dangers posed by the potential flights of their derivatives portfolios. The AIG Fiasco AIG, the most egregious example of the first type, was bailed out in response to losses suffered by its subsidiary AIG FP, which had sold CDS protection on over $400 billion of CDOs. As AIG’s losses mounted, downgrades to its credit rating were about to trigger contractual obligations for AIG to post large amounts of additional collateral on its CDS positions. AIG did not have the resources to meet these calls for more collateral. The federal government stepped in to support AIG, at a massive cost to U.S. taxpayers. Clearing would not have helped here. The AIG credit derivatives contracts were customized to the particular CDOs that they covered. Even had CDS clearing existed at the time, these AIG CDS would not have been sufficiently standard to have been cleared. Only better risk management by AIG and better regulatory supervision could have prevented this disaster.
In my view, CDS and the entire OTC derivatives market represents a form of regulatory arbitrage – a retrograde and deliberate evasion of established prudential norms masquerading under the innocent guise of innovation. As in the case for the OTC market for unregistered securitizations, OTC derivatives are essentially designed to generate supernormal returns for a relatively small group of global banks which traffic in these officially sanctioned, but private gaming contracts. The practical problems with CDS contracts come from several basic flaws in the regulatory, legal and business model for these instruments, deliberate flaws that include: An archaic, bilateral clearing scheme that has only recently begun to be reformed, A deliberate lack of standardization and price transparency that advantages the CDS dealer No common central counterparty to guarantee all trades and to hold collateral, and thus no effective limit dealer leverage A schizophrenic pricing methodology that has little connection to the several different types of underlying market and credit risk contained in CDS contracts
Reform is necessary to re-establish confidence in the financial system, particularly among global investors. The reform proposal is well thought out, at least in theory; it attempts to fill most of the cracks in the regulatory framework, cracks that contributed significantly to the current financial crisis. Even with the reforms implemented we would have decreased the impact of this financial meltdown.
On March 12, 2009, International Swaps and Derivatives Association, Inc. (ISDA), published the Credit Derivatives Determinations Committee and Auction Settlement Supplement (the “Supplement”) and Protocol (the “Big Bang Protocol”). The Supplement will introduce four broad changes into the Credit Default Swap (“CDS”) market that will be applied to new CDS trades and can be applied to existing CDS contracts via adherence to the Big Bang Protocol. Each of these changes is outlined in the discussion below. And these became effective from April 8 2009. The changes made by the ISDA were: Adopts the auction model as the default settlement mechanism based on the documentation used in connection with previous credit derivative auction protocols; Establishes Credit Derivatives Determinations Committees (“Determinations Committees”) for the purpose of making determinations with respect to credit events and succession events, for overseeing the auction process (and any modification required for a specific credit event) and for addressing other issues presented by the CDS market; Establishes a credit event backstop date and a successor event backstop date; and Modifies currency exchange rates and related provisions for physical settlement and the auction settlement process to eliminate the perceived inequity relating to foreign exchange provisions with respect to the use and amendment of a Notice of Physical Settlement during the settlement of CDS trades.
ISDA has also announced a new Standard North American Corporate CDS contract, nicknamed “SNAC.” SNAC is a single-name CDS contract with a fixed coupon of 100 or 500 basis points, depending on whether the Reference Entity is considered investment grade (for which the fixed coupon is 100 basis points) or high yield (for which the coupon is 500 basis points). SNAC contracts will also trade without Restructuring as an applicable credit event. Note that adhering to the Big Bang Protocol will not convert existing CDS contracts to SNAC. The Big Bang Protocol and the new SNAC contract are separate ISDA initiatives that will take effect on the same date.
The three main derivative reform proposals under discussion – On July 30, 2009, the chairs of the House Financial Services Committee and the House Agriculture Committee outlined their joint principles for new derivatives legislation (the Frank- Peterson principles) On August 11, 2009, the Obama administration released its proposed “Over-the-Counter Derivatives Markets Act of 2009” (the Treasury plan) On June 26, 2009, the House passed the American Clean Energy and Security Act (Waxman-Markey), can be evaluated with respect to several stated policy options that are believed, in varying degrees, to reduce systematic risk and improve the efficiency of the derivatives markets. They are: Centralized clearing, Improved price transparency, Improved position transparency, Migration of over-the-counter trading to exchanges, Speculative position limits, and Improved corporate governance in the area of risk management.
A move towards the centralized clearing of OTC derivatives is an important component of all of the proposed packages of reforms. A contract is cleared when a central clearing counterparty, informally known as a “clearing house,” legally assumes the position of buyer from the original seller, and seller to the original buyer. The original counterparties post initial performance margin with the clearing house. As the position is marked to market each day, they pay or receive “variation” margin in recognition of any reductions or increases in the market values of their positions. These margin payments are normally made in cash or treasury securities. Clearing insulates counterparties from each other, provided that the clearing houses are themselves well designed and capitalized. In addition to any direct reductions in counterparty risk, clearing reduces the sort of run-on-the-bank behavior that was likely to have quickened the failures of Bear Stearns and Lehman. The main concern is how to encourage the growth of effective central clearing. Clearing is a relatively expensive process. For each type of derivatives contract, a clearing house must set up standard terms for acceptable contracts, determine formulas for initial margins, and set up a methodology for pricing cleared derivatives for the purpose of determining variation margin payments. Proper financial controls and carefully crafted legal contracts are required. Systems for the processing of trades and collateral are needed. Because of these costs and because of the requirement for daily or even more frequent pricing, it only makes sense to clear types of derivatives that are relatively “commoditized,” that is, widely and heavily traded in a standard form. In July 2009, Eurex began clearing CDS contracts, partly in response to the European Commission’s demand that dealers arrange for separate Europe-based clearing of Eurozone credit default swaps. In general, counterparty risk is higher when clearing is separated across clearing houses. This follows from the lost opportunity to offset the exposures that can arise when a financial institution’s cleared derivatives positions have a net negative market value at one clearing house and a net positive market value at another clearing house. From this viewpoint, it is better to have a small number of central clearing counterparties, and to have joint clearing of interest-rate swaps, credit default swaps, and other derivatives. National regulators would do well to cooperate on the regulation and supervision of clearing houses. Among the issues to be resolved for the effective international supervision of clearing houses is the division of responsibility for bailouts, should a clearing house need government support. Overall, while the clearing of inter-dealer OTC derivatives positions is still quite limited, the clearing of positions between dealers and their customers is even less common. The New York Fed has asked dealers to arrange for more clearing of customer positions. The development of new frameworks for clearing customer-to-dealer CDS positions is in progress. In summary, the increased use of central clearing represents the most powerful way to reduce systemic risk arising from OTC derivatives markets. Some key steps that regulators should take are: (1) pressuring dealers to adopt specific numerical targets for lowering exposures (before collateral) on uncleared derivatives positions, (2) increasing regulatory capital requirements for uncleared versus cleared derivatives, (3) persuading dealers to clear a greater fraction of dealer-to-customer positions, and (4) fostering international coordination in the regulation, supervision, and failure resolution of clearing houses. It would be counterproductive, in my opinion, for regulators to reach for legal definitions of the types of derivatives that are to be cleared.
Markets tend to be more efficient when the “going price” is well known by market participants. OTC derivatives markets have limited price transparency. For relatively standard types of derivatives, such as certain interest-rate swaps and credit default swaps, representative quotes are published through financial reporting services such as Markit Partners and Bloomberg, or on inter-dealer broker screens. Customers of dealers are nevertheless normally much less well informed about recent execution prices than are the dealers with whom they execute their trades, and are thus at a bargaining disadvantage to the dealers. This is not a big issue from the viewpoint of systemic risk, but it is a relevant concern with respect to market efficiency and the division of gains from trade between dealers and their customers. But on the other side from dealer’s point of view with more improved price transparency would reduce the incentives of dealers to make markets because the customers will be having the price of previously traded contract and in the end reduce market liquidity.
A separate issue is the availability of data on the sizes of derivatives positions, which allow the monitoring of risk concentrations that can have systemic implications. There are concerns, however, about what amount and type of data is appropriate to be disclosed, and to whom. The Treasury plan and the Frank-Peterson principles call for all OTC derivative trades to be reported to qualified trade registries. The Treasury plan also calls for public disclosure of aggregate position information, and proposes that individual positions should not be disclosed.
Public disclosure of market-aggregated position sizes seems well warranted. Currently, for example, for each of 1,000 large corporate or sovereign borrowers, DerivServ discloses the total quantity of CDS positions that are held as protection against the default of the borrower. This “open interest” information assists investors in judging the degree to which investors, in aggregate, are concerned about the creditworthiness of individual borrowers, as well as the degree to which sellers of protection in the CDS market could be harmed, in aggregate, if the borrower defaults. The BIS, the Office of the Comptroller of the Currency, ISDA, and other agencies provide some aggregate market position information, although the frequency of these reports and their coarse levels of aggregation leave room from significant improvements in the information that investors can collect on OTC market risks. Regulators should push, in broad set of active OTC derivatives markets, for something akin to the frequency (weekly) and degree of refinement of DerivServ open-interest reporting. For example, had the DerivServ Trade Information Warehouse, which now provides electronic documentation of almost all standard CDS contracts, not existed by the time of the financial crisis, the default of Lehman Brothers would probably have been accompanied by substantially greater market uncertainty, and potentially by panic as dealers and others attempted to determine the extents of their CDS exposures. In fact, the CDS positions triggered by Lehman’s default were well documented and were settled in an orderly manner. All recorded sellers of protection performed on their obligations.
It is sometimes claimed that OTC derivatives pose dangerous risks because the public does not have the opportunity to see the sizes of positions held by individual investors. OTC derivatives markets are no more opaque in this respect than organized derivatives exchanges. Indeed, individual positions are almost never disclosed in any financial markets. The main exception is the SEC requirement for investors in the common shares of public corporations to disclose holdings once they exceed given thresholds, relative to the total number of outstanding shares. These equity position disclosures are not motivated by systemic risk monitoring, but are instead designed to address issues related to the potential control of U.S. corporations. Derivatives positions do not convey control. In general, the public disclosure of individual derivatives positions would reduce the incentives of investors to collect and analyze fundamental information. The efficiency with which prices are determined would decline correspondingly. Privacy concerns might also be raised. The public disclosure of individual derivatives positions should not be mandated as an approach to reducing systemic risk unless there is compelling evidence that disclosure to regulators alone is not sufficient. There is, however, a good case for mandating the public disclosure of derivatives positions (whether obtained on exchanges or over the counter) that offset the economic exposures of major holders of debt or equity in public corporations. For example, the public has an interest in discovering whether a major shareholder, who ostensibly contributes to proper corporate governance, has severely diluted its governance incentives through a derivatives position. Likewise, the major creditors of a distressed corporation are normally presumed to act in a manner that mitigates distress costs. If, however, a creditor has purchased protection against default using credit derivatives, the creditor may even have a net incentive to accelerate the default or may have a substantially diluted interest in raising the recovery value of debt claims. In general, regulators should rationalize disclosure requirements for derivatives positions that raise substantial concerns over moral hazard in corporate governance.
Because derivatives traded on exchanges have almost immediate price transparency and are almost invariably cleared, exchanges offer obvious improvements over OTC trading for those types of derivatives that have enough volume of trade to justify the setup costs of exchange trading. Once traded on exchanges, moreover, a broader set of investors can take part in the benefits of hedging and speculation, and can further add to market efficiency and, particularly, liquidity. Dealers, however, reap substantial profits from OTC trading, and have little incentive to foster the migration of trading from the OTC market to exchanges, even after a derivative product achieves a high level of standardization and breadth of investor activity. Anyone suggesting otherwise should be embarrassed by the examples of standardized and extremely heavily traded derivatives that are available only in the OTC market, such as “CDX.NA.IG” default-swap index derivatives, which are based on a basket of bonds issued by large investment-grade North American corporations. I can think of no good reason that the public interest is best served by having such benchmark financial products available only through negotiation with dealers. There also exist electronic trading platforms that offer a degree of price transparency and breadth of access lying between the extremes represented by fully private OTC negotiation and central exchange trading. These platforms are organized by dealers, inter-dealer brokers, or specialty financial services firms such as TradeWeb or BrokerHub. On such platforms, dealers compete for orders by displaying quotes. Typically, counterparties can contact other counterparties offering quotes, and then complete the negotiation of trades in private. More extensive use of electronic trading platforms and of TRACE-like price transparency would reduce the inefficiencies associated with OTC market opaqueness. Indeed, the Treasury plan would require that all standardized derivatives be traded on exchanges or on “alternative swap execution facilities,” apparently referring to trading platforms of the sort mentioned above. Forcing derivatives trading onto exchanges by regulation must nevertheless be done with caution. It is not easy to gauge the costs and benefits, case by case. Simple rules based on measured volume might encourage unintended behavior by dealers, such as using excessive customization to limit the development of liquidity. Further, even for relatively high-volume products, OTC markets are sometimes able to handle very large trade sizes more easily than exchanges, just as large blocks of equities are often handled by private negotiation despite the availability of active equity exchanges. Beneficial financial innovation could also be stifled if OTC derivatives are regulated onto exchanges before dealers can generate a sufficient return on their investment in developing new financial products.
It has been proposed that speculative derivatives trading should be severely curbed, or even — in the case of CDS markets — outlawed. These proposals are based, at least in part, on a misconception of the role of speculation. The U.S. House of Representatives has voted in favor of Waxman-Markey, which, if passed without alteration, would prevent an investor from entering into a credit default swap unless the investor has an associated commercial business exposure to the borrower named in the CDS. (The disallowed trade has been called a “naked CDS.”) This measure is seriously flawed. If it is enacted, an investor that does have a commercial hedging need for CDS protection would often face difficulty finding a suitable counterparty. Apparently, the counterparty would also be legally required to have a commercial need to hedge against the default of the same borrower. The elimination of speculation through this measure is analogous to regulation against hurricane insurance. Insurers have no natural hedging motive in offering hurricane insurance. They are effectively speculators. That is, they believe that the likelihood of a hurricane is low enough relative to the insurance premium that they can generate an expected profit on each new policy, although taking the risk of a significant loss in the event of a hurricane. To the extent that insurers are prevented from speculating in this manner, those with a desire to reduce risk by purchasing insurance would lose access to counterparties willing to bear the risk, or would pay a much larger insurance premium given the resulting scarcity of risk-bearing capacity. A related measure, proposed by George Soros and included as a legislative option in the Frank-Peterson principles, would allow speculators to sell default protection but not to buy default protection. Such a rule would lead to a loss of market liquidity and a reduced quality of price discovery. Suppose, for example, that the CDS market currently offers protection on a named borrower at a premium that is much lower than the borrower’s poor financial condition actually warrants. Under the proposed regulation, speculators would not have the incentive to discover the true financial health of the borrower, buying protection until the market price of protection rises, thereby revealing the weakness of the borrower to everyone. Outlawing the speculative use of credit default swaps to buy protection would have the unintended consequences of reducing market liquidity (because those selling protection would have less incentive to incur the costs of remaining informed and active traders) and of driving this form of speculation “under the radar,” through the use of less effective and transparent types of financial products. There are no specific regulatory limits on the sizes of OTC derivatives positions that may be held by a hedge fund, although dealers holding the other sides of these positions indirectly limit systemic risk to some extent through their own limits on counterparty exposures and with the collateral requirements that they impose on hedge funds. Through laws that prohibit price manipulation, the SEC and the CFTC already have an adequate legal framework for pursuing anyone attempting to corner or otherwise manipulate organized securities or derivatives markets. For example, both the CFTC and the Federal Energy Regulatory Commission (FERC) charged Amaranth with market manipulation over its natural gas futures positions. The proposed Treasury plan includes several new measures designed to limit manipulation of OTC derivatives markets, mainly with respect to trading on “alternative swap execution facilities.”
Derivatives that are not easily cleared or exchange traded are typically those customized to suit the specific business uses of investors. There should be some tolerance for financial innovation and customization. Economic efficiency is harmed if those with commercial needs for hedging are forced entirely into standard derivatives positions that are relatively poor hedges, or if derivatives markets are unable to innovate along with changes in the economy. For example, when interest-rate swaps first appeared in the 1980s, they were low-volume customized financial instruments. Had non-standard derivatives been heavily penalized at that time, a useful financial innovation could have been stifled. The AIG derivatives fiasco was extremely costly to taxpayers. The AIG credit default swaps would not have been sufficiently standard to be cleared. By their nature, the risks of customized derivatives are more difficult to monitor than those of standard derivatives. Risk management by AIG’s senior management and board, and supervision by the regulator of its derivatives activities, the Office of Thrift Supervision, were inadequate. In my opinion, corporate boards and regulatory supervisors should have more effective risk management credentials or training. The quality of risk management by corporate boards might also be raised by the increased use of professional services in “risk auditing,” in the manner that boards currently rely on independent financial accounting auditors.
Policymakers should keep in mind that markets evolve. Markets cannot be created by government fiat, and they are distorted by government intervention.Where regulation is necessary, it should be flexible enough to allow continued market evolution and to respond to that evolution in appropriate ways. Sound regulation interacts with markets rather than insisting that markets conform to preconceived government categories and jurisdictions.While central clearing for many CDS contracts is now feasible, regulations should remain sufficiently flexible to allow new or revised credit products to trade and develop in non-cleared markets.Over time, successful products will develop sufficient volume and standardization to permit clearing or exchange trading. However, imposing such requirements on new products when they are initiated initiated would prevent useful experimentation and market evolution.Those who would disrupt derivatives market improvements by mandating a change in regulatory jurisdiction should be required to meet the high burden of proof that the regulatory disruption is both necessary and likely to improve current arrangements. The House Agriculture Committee’s proposal to restrict derivative clearing to CFTC-regulated clearinghouses fails both prongs of this test.
In order to reduce systemic risk arising in derivatives markets, regulators should push for more extensive clearing through immediate pressure on dealers for numerical targets and, as soon as possible, through revisions to regulatory capital requirements. Regulatory language that defines the specific types of derivatives to be cleared would have counterproductive unintended consequences. Derivatives positions should be comprehensively disclosed to regulators, and should be disclosed to the public only after aggregation, except for cases in which the disclosure of specific individual positions would inform the public about significant moral hazards in corporate governance. In order to improve market efficiency, over-the-counter prices should be published much more systematically, for example through TRACE-like post-trade reporting systems, which should be mandated for at least all cleared derivatives. Greater competition, even within the OTC market, can be achieved with more effective and widespread use of electronic trading platforms. Regulators should foster the migration of trading from over-the-counter markets to exchanges whenever warranted by sufficiently active trading. Severe curbs on speculation detract from market efficiency and increase price volatility. Speculative position limits should be adopted only where valid concerns over systemic risk or market manipulation cannot be addressed by other means. Corporate boards should be encouraged to improve their corporate governance in the area of risk management, for example from increased representation on boards of suitable specialists or by the retention of professional risk auditors. All that I am suggesting today is that we bring the CDS market fully into the light of transparency by listing most of these contracts on exchanges, that we require adequate capital and collateral for all players in both exchange and OTC markets, for end users and dealers alike; and that we force parties writing default protection to show that they understand the risk implications of same.
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