The arguments for stronger derivatives reform

By Felix Salmon
March 5, 2010

The NYT comes out swinging today, devoting a long editorial to the subject of derivatives reform, under the headline “A.I.G., Greece, and Who’s Next?”. The headline alone made me ill-disposed towards the editorial, even before I got to this:

First came the news that Greece had entered into derivatives transactions with Goldman Sachs and other banks to hide its public debt. Then came reports that some of those same banks and various hedge funds were using credit default swaps — the type of derivative that kneecapped the American International Group — to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro.

What a mess. The news that Greece had entered into derivatives transactions with Goldman Sachs came in 2003, almost seven years ago. The reports about hedge funds using derivatives to bet against Greece and the euro have already been discredited. And AIG was not brought down because people were buying credit protection on it, it was brought down because it was selling credit protection on subprime mortgage bonds.

I’m conflicted about this editorial, because some of its arguments end up in the right place. But the problem is that it gets to the right destination by using the kind of rhetoric which makes it seem as though the only people who are unhappy about proposed derivatives regulation are the people who don’t understand the derivatives market.

“Because the markets in which they trade are largely unregulated,” says the editorial, “derivatives can too easily become tools for dangerous risk-taking, vast speculation and dodgy accounting.”

But dangerous risk-taking is actually a good thing, in financial markets. When people engage in risky behavior on Wall Street, they stand to lose a lot of money, but they know that they stand to lose a lot of money, and government doesn’t end up having to step in and bail them out. The big systemic problems happen when leveraged actors think that they’re not engaging in risky, speculative behavior — when banks become complacent about the credit risk in anything carrying a triple-A credit rating, for instance, or when prime brokers are so overconfident with regard to prices moving smoothly and continuously that they unwittingly put themselves on the hook should a highly-levered fund like LTCM suddenly face discontinuous markets.

The editorial continues:

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings. Private markets also lack the rules that prevail in regulated markets — like capital requirements, record keeping and disclosure — that are essential for regulators and investors to monitor and control risk.

This is typical of the piece: it’s largely wrong, and then it’s right. The CDS market is actually more transparent, with smaller bid-offer spreads, than the cash bond market, and the OTC market in interest-rate swaps, for instance, is likewise just as transparent and participant friendly as its exchange-traded counterpart. Moving trading onto exchanges means lower profits for banks, to be sure — because the trading is moved out of the banks’ trading floors and onto the exchanges. But it doesn’t necessarily mean lower trading costs for the buy side: just ask anybody who tries to buy and sell bonds listed on the Luxembourg exchange.

On the other hand, the editorial is quite right that it’s important for prudential regulators, who are charged with keeping an eye on all the risks in the financial system, to be able to at least see what’s going on in the world of derivatives. And that’s much easier when trading takes place on exchanges than when it’s hidden in bilateral contracts between thousands of different players in dozens of different countries.

The editorial then complains about what it calls a “huge loophole”: the fact that fx swaps are not included in the move to exchange trading. “The rationale for the exclusion never has been clearly explained”, it says; maybe I can help out here. There are a bunch of reasons to exclude fx swaps, including the fact that they take place in a regulated interbank market and are intermediated by CLS Bank, which is also a regulated institution.

But I’m still sympathetic to the NYT’s case here. The administration says that it’s going to give the CFTC broad anti-evasion powers to ensure that firms do not recharacterize interest rate swaps and currency swaps as FX transactions — but no one knows whether and how the CFTC will be successful in that. And the administration isn’t good at explaining why making this recondite distinction between currency swaps and fx swaps (don’t ask) is particularly necessary. Why not just apply the same rules to everything?

Similarly, the editorial is right about the end-user loophole. It’s been tightened up a lot, but why have it at all? I’m sure that banks have the imagination to be able to construct customized hedges for their clients using nothing but publicly-traded derivatives — at least close enough to make most corporate treasurers happy. Yes, those treasurers might have specific needs, but if their hedges aren’t 100% exact, it’s not the end of the world. 95% will be good enough, and might in fact keep those treasurers on their toes a bit more. It’s not good to offer 100% hedges, since perfect hedges don’t exist in the real world, and you don’t want to breed complacency in the CFO’s office.

But this makes little sense to me:

When the House put out a draft of new rules in October, it sensibly gave regulators the power to ban abusive derivatives — ones that are not necessarily fraudulent, but potentially damaging to the system. Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent.

This sounds to me that the NYT wants to ban — or at least give regulators the ability to ban — credit default swaps outright. I’ve written at some length about the incentives facing CDS holders who might profit from a default, but there aren’t evil speculators destroying companies with credit default swaps any more than there are evil speculators destroying companies through naked shorting. Remember that there’s no evidence whatsoever of CDS speculators causing difficulties for Greece. None. Zero. So let’s not get carried away with ourselves here.

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