8/9/2019 Financial Times - A Small Step In The Right Direction

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16 FINANCIAL TIMES MONDAY AUGUST 2 201

FTfm report Clearing OTC derivatives

A small step in the right direction

The move to regulatederivatives tradinghas been well

received but the devil, andeventual effectiveness ofr ef or m, w il l b e i n t hedetails that will be years inthe making.

Insurer AIG had moret ha n $ 50 0b n ( 3 21 bn ,

384bn) in credit defaultswaps on its books in 2007.

In December, as marketc on di ti on s w or se ne d,Joseph Cassano, who hadrun the companys deriva-tives unit, told investorsthese positions would needto be marked down onlymodestly.

The following year, theUS bailed out AIG to thetune of $182bn.

There was not anythingfundamentally wrong withderivatives that hedgedagainst a bond default. Butt he c re at io n o f c re di tdefault swaps without suffi-cient capital behind themrevealed just one of manyexamples of how exposedthe US economy was to ill-

conceived derivatives. Mak-ing matters worse was theh ug e i nf or ma ti on g ul f between what underwritersknew and what buyers didnot know, which preventedt he m ar ke t f ro m s el f-correcting.

The passage of the Dodd-Frank Wall Street Reformand Consumer ProtectionAct responds to this and themany other market failuresthat brought the US econ-omy to its knees. Politicalrhetoric aside, virtually allobservers believe the act isa step in the right direction.

The move to shift themajority of derivative trad-ing to exchanges and clear-ing houses will help lowerrisk, according to the direc-tor of public affairs at theUS Commodity F uturesT ra di ng C om mi ss io n,which, in concert with theSecurities and ExchangeCommission, will translateCongressional intent intopractice.

T he D od d- Fr an k A ctrequires prudential regula-tors to set minimum capitalrequirements, while clear-inghouses require pricingregularly marked to mar-ket. Just as important, reg-ulators will establish stand-ards of business conduct,including record keepingand reporting so regulatorswill be able to mon itor

transactions.

But it is far from certainwheth er the n ecessarystandards needed to imple-ment these changes will beenacted. These are thedetails that must be workedout.

Henry Kaufman, an eco-nomic and financial con-sultant, believes reliance onclearing houses will helpenforce key trading require-men ts and mitigate thepotential impact of counter-party risk.

This will help us avoidone source of difficultiesthat fuelled the financialmeltdown in 2008, he says.But he remains scepticalthat a k ey fun damentalissue will be addressed.

The vast majority of thederivative market is under-written by five to six majorfinancial institutions, saysMr Kaufman.

He does not believe thatnew rules will alter thisfact, leaving in place thesystemic problems of con-

centration and financial

organisations that are toobig to fail.

It w il l t ak e y ea rs t oeffect the new regulationsand the interests of theseinstitutions will be well rep-resented in the process,warns Mr Kau fman . Hefears one such place of com-promise will involve propri-etary trading, where therecan be serious conflicts ofinterests.

Mr Kaufman is also con-cerned that there may beinsufficient transparency todiscern full underwriterderivative exposure byscale, sector concentration,and event exposure.

A chief economist at oneo f U S s l ar ge st b an ksshares this concern in see-ing the likely continuationof asymmetric infor-

mation. Not only does thislead to compromised deci-sion-making on the buy-side, he says, but directlyc on tr ib ut es t o e xc es sreturns when buyers cantcompare risks and prices.

He is unsure how regula-tors will devise new rulesthat will address theseissues, and does not believet ha t c le ar in g i n t hi sinstance will make muchof a difference.

There will also be addi-tional costs related to mar-gin requirements. TitanCapital Group, a hedge fundman ager with $400m inassets, relies largely onderivatives to execute itsvolatility trading strategy.Russell Abrams, president,says the market still doesnot know how much mar-

g in r eg ul at or s w il lrequire. But however

much it is, it willcut into returns.

Th e c ur re ntspike in impliedvolatility espe-cially involving

eq uit y i ndexoptions that go out

10 years and longer s ug ge st s t he

market is pricing in highermargin costs, Mr Abramssays. N everth eless, h ebelieves reform will lead toa reduction in leverage andhelp ensure a more stablefinancial system.

Even before the financialcrisis h it, Calpers, the$205bn California pensionfun d, h ad increasin glyrelied on collateral supportagreements, which is com-parable to the use of mar-gins. Eric Busay, head ofthe funds foreign exchangeand internation al fix edincome exposure, explainsCalpers is already movingin the direction in whichthe reforms are heading, sohe thinks the evolving ruleswill not materially affectthe way Calpers functions.

Viral Acharya, a profes-sor at New York Univer-s it y s S te rn B us in es sSc hool, ag rees thatimproved transparency pro-vided through clearing willenhance the efficiency ofderivatives markets.

But he is concerned howthe governmen t wou ldintervene if clearing houseswere hit by the same blowthat hit traders severalyears ago.

These structures arentbanks and how governmentcould provide liquidity isnot clear, says Mr Ach-

arya. The CFTC think s

clearing inherently providethe necessary backstop tprotect the system. Whil

its spokesman admits thfull network is not yet iplace, exten sive dealem em be rs hi p i n t he shouses and the extensivmargin that wil l binvolved in clearing derivtive trades will mutualisrisk, he says.

The CFTC is also optimitic that requiring dailmark to market pricing currently not necessary fobilateral agreements wienhance visibility of condtions, as will consistenreporting to regulators.

Contrary to Mr Acharyap oi nt , he say s und eextreme circumstan ceclearing houses can geaccess to Federal Reserv

capital.To Jonathan Kanterman

managing director of Stilwater Capital, a $750m funof hedge funds, regulatormust use this moment tcosmically alter their treament of CDSs.

Once and for all themust recognise these contracts as insurance policieand require sufficient captal reserves, says Mr Kanterman.

He points out that thmajority of the $787bn Ubail-out programme actually went to stabilise CDtrades. The issue is espcially critical, h e saywhen we see underwritin

of swaps that are mantimes the size of the underlying debt.

Even with sufficient capital, this could lead to dyfunctional, destructive maket behaviour, Mr Kanteman says.

Second, he wants bonown ersh ip rights to baffected by the degree oCDS exposure. Theres thpotential for a conflict ointerest by debt holderwho could stand to profmore from bankruptcy tharestructuring, explains MKanterman. And he woullike to see limits placed ot he p ur ch as e o f n ak eshorts default protectiowithout ownership of thunderlying security. MKaufman agrees.

Like many regulatorchanges necessary to effecreform, Mr Kaufman wories the new rules will nobe able to limit the use oderivatives for speculativpurposes.

Use of derivatives in thiway exacerbated the impacthey had in the financiac ri si s, ob ser ves MKaufman, and going foward, without meaningfurestrictions over the orignation and trading of thessecurities, they could agaisend serious shock wavethroughout the financisystem when we are hit b

the next seismic event.

Crisis evasion

Moves to regulatederivatives have notaddressed all theinherent risks. EricUhlfelder looks atsome of the issues.

Calpers, the $205bn California pension fund, has been using collateral support deals for some time Getty

Even withsufficient capital,this could leadto dysfunctional,destructivemarket behaviour

HenryKaufman: Itwill takeyears toeffect thenewregulations