Commentaries

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

What’s the Justice Department’s angle on derivatives?

Lots of posts and articles are circulating about the Department of Justice’s investigation into the derivatives market and specifically the dealers that own Markit – the administrator of popular credit default swaps indexes and aggregator of CDS prices.

Yet, I must say I’m not sure what the investigation hopes to turn up. Instead, it looks more like the Obama Administration flexing its muscle to let banks know that it’s serious about derivatives regulation just in case they didn’t get the point when the government released its white paper on regulatory overhaul last month.

From the Bloomberg article:

Justice Department investigators want to know if Markit’s bank shareholders received advantages as owners and providers of prices and trading patterns for credit-default swaps, said two of the people. The data from the market’s largest users is provided to more than 300 financial firms to set prices of the contracts in their portfolios, according to Markit’s Web site.

The notices ask recipients to give the Justice Department details on the amount of their trading, how much they have at risk in the market, the monthly value of their credit swaps and other information, said a person who read parts of the letter to Bloomberg News.

But it’s the dealers themselves that provide Markit with the data, not the other way around. So how much advantage could they actually get from using Markit data before everyone else?

Naked Capitalism also seems puzzled and points out that even if they did have privileged information, that’s not necessarily illegal.

As much as I would love to see the credit default swaps market reined in, or better yet, shut down, this move is puzzling. CDS are unregulated. Therefore there is no such thing (legally) as insider trading. Even in regulated commodities markets, there is no such thing as insider trading, since no one in theory had the advantaged position relative to the market in a commodity that corporate insiders do relative to a business.

So what legal theory is the DOJ operating on? Insider trading and front-running are SEC notions, and SEC regulations don’t extend to CDS, save any registered securities that had embedded CDS. The letter came from the antitrust division, so the theory may be abuse of monopoly position (as in, relative to those contracts). But Markit is headquartered in London, which also raises jurisdictional issues.