The Politics of Regulating Derivatives
The debate surrounding the CCP provides insight into the complex interest of different groups affected and the lobbying process shaping the regulations.
The CCP proposals do not encompass full standardization or listing of derivative contracts, due to significant resistance from the industry.
Proponents argue that the over-the-counter trading format is essential to enable users to customize bespoke solutions to match underlying financial risks. They also argue that the flexibility of the OTC market is essential to financial innovation. Critics argue that without full standardization, markets will remain opaque and lack transparency. They allege that the lack of formalized trading and poor price discovery allows dealers to earn substantial economic rents from trading. Derivatives dealers cite Walter Bagehot's famous observation about the English monarchy, "We must not let daylight in upon the magic."
Regulatory proposals require that derivatives eligible for clearing be traded on a new exchange-type trading system -- swap execution facilities (SEFs) -- to increase transparency, improve liquidity, increase competition, and lower transaction costs.
Existing exchanges, electronic trading platforms, and interdealer brokers are already seeking to establish accredited SEFs. In the oligopolistic world of OTC derivatives trading, less than 10 dealers (nicknamed "The Derivatives Dealers Club" by Robert Littan of the Brookings Institute) control the bulk of trading activity.
As they provide the bulk of trading volume that will dictate the success or failure of individual ventures, these dealers are positioning to control trading through ownership or influence over platforms. As a result, a few SEFs, directly or indirectly controlled or heavily influenced by existing OTC derivatives dealers, are likely to dominate.
The CCP is intended for "standardized" derivatives. On Capitol Hill in 2009, when asked what was to be included, Treasury Secretary Timothy Geithner said that he would have to get back to his interlocutor on that point.
In a curious circularity, standardized now means anything that is eligible for and can be "cleared." Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are evident.
Foreign exchange (FX) swaps and forwards were originally mysteriously excluded from the definition of "swap" and exempted from clearing. Then, the exemption was removed. Following renewed debate, in April 2011, Geithner exempted all FX derivatives from clearing.
The case in favor of exemption argues that FX contracts predominantly have short duration with low risk. The primary risk of FX contracts, dealers argue, is settlement risk; that is, the cross border funds transfer risk on payments. The dealers believe that settlement risk is already mitigated by CLS Bank, an industry initiative, which since 2002 has provided central settlement in 17 major currencies across six instruments, including FX swaps and forwards. Dealers argue that the FX market functioned well during the financial crisis with no obvious problems and does not need mandatory clearing.
There are substantial reasons for FX contracts not to be exempted. The FX market globally is very large. It is growing rapidly, with current daily turnover of $4 trillion (7% of global GDP) expected to rise to $10 trillion by 2020. The level of speculative activity is significant, with only around 3% of trading related to underlying trade flows. The FX market is highly significant economically and commercially. Financial institutions from almost every country are active in it, and any problem could pose systemic risks.
It is also difficult to differentiate the risk of an FX derivative contract from derivatives in other asset classes. Risk of FX contracts, despite their short maturities, can be larger than longer dated interest rate contracts, primarily due to the volatility of currencies and also the settlement mechanics.
Regulators are developing elaborate rules that specify included and excluded entities. Derivatives or swap dealers are required to deal through the CCP. "Major market participants" who are not dealers must also clear standardized derivatives through the CCP.
Industrial companies do not want to be subject to the requirement to clear derivatives through the CCP, arguing they only trade to hedge risks. They also argue that the CCP is complex and would place uncertain liquidity demands on their cash flows.
Exemption of instruments, asset classes (such as foreign exchange), and participants reduces the effectiveness of the CCP.
The system of exclusions and exemptions also sets up complex loopholes, begging to be exploited. Standardized contracts may be restructured into nonstandard instruments that do not require clearing. Dealers may be able to restructure organizationally to avoid clearing requirements for parts of their business. Large derivative users, not classed as swap dealers, but systemically significantly, may be excluded.
To the extent that products are not routed or counterparties are not obligated to trade through the CCP, existing problems remain and new unanticipated risks may emerge. But as American radio and television commentator Charles Osgood observed, "There are no exceptions to the rule that everybody likes to be an exception to the rule."
(See also: Central Counter Party: How Effective Is This Model at Reducing Derivatives Market Risk?)
Earlier versions of this piece have been published as "Tranquillizer Solutions Part I: A CCP Idea" and "Tranquillizer Solutions: Part 2 – CCP Risk Taming" in Wilmott Magazine (May and July 2011)
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