|
By Ronald Fink
The Obama administration’s plan for derivatives regulation may be well intentioned. But it falls well short of what’s necessary to prevent another financial crisis, according to a growing chorus of critics.
The plan calls for standardized contracts to be traded on exchanges. Customized synthetics would be left to over-the-counter markets, which would, in theory, by subject to tighter regulation.
But by failing to re-establish a legal distinction between speculating and hedging with derivatives in the OTC market, the Obama administration intends to let dealers in credit default swaps engage in unrestrained risk, critics contend. These critics are pushing the administration to require that at least one party to such a deal certify that it has an “insurable” interest in the underlying credit, and thus is hedging a real business risk.
That party would have to demonstrate its interest to regulators. Transactions where there is no such business interest involved are called naked swaps.
The issue has repeatedly come up during recent hearings of the House Financial Services Committee. Debate over naked swaps is likely to heat up during meetings of a Congressional commission set up to study the causes of the financial crisis. That commission, which is slated to hold hearings soon, is charged with recommending regulatory changes to prevent another meltdown. Former California state treasurer Philip Angelides was named last week to lead the commission, which is known as the Financial Crisis Inquiry Commission.
“It is extremely important” to re-impose a legal distinction between speculation and hedging, Brooksley Born, former chairman of the Commodity Futures Trading Commission—and one of 10 members of the commission—said in an interview with CFOZone.
Such a distinction was in place prior to 1993, when the CFTC granted an exemption from state “gaming” laws to dealers on the grounds that derivatives were regulated by federal authorities. Seven year later, the Commodity Futures Modernization Act exempted derivatives from federal oversight as well. Born’s objection to that piece of legislation was over-ridden by others in the Clinton Administration, including assistant Treasury secretary Lawrence Summers, now President Obama’s chief economic advisor.
The law, Born said, led to speculation in credit default swaps. Ultimately, the frenzy led to excess. The poster child for that excess, insurance giant AIG, had to be bailed out by the federal government after the insurer could not come up with enough collateral to back the swaps it had sold to banks and investors.
Other critics are not fond of the Commodity Futures Modernization Act, either. “It opened a floodgate,” former SEC chairman William Donaldson said at a recent press conference that unveiled the recommendations for financial regulatory reform of the Investors’ Working Group. Donaldson co-chairs the group with fellow former SEC chairman Arthur Levitt. The panel, which is sponsored by the CFA Institute and the Council of Institutional Investors, is crafting recommendations aimed at eliminating excessive risk in the U.S. financial system.
Among the IWG’s recommendations: a requirement that at least one party to a deal certify and be able to demonstrate that it is buying a contract to hedge business risk.
“I am extremely supportive” of the IWG ‘s recommendation, said Born, who is a member of the group. “Any OTC market is more difficult to regulate than an exchange-traded market.”
Some proponents of credit defaults swaps contend that concerns about speculation involving them are overblown. They note, for example, that estimates of the total notional value of the swaps outstanding at any given moment do not accurately reflect the amount of money at stake, since a sizeable chunk offset each other.
“The amount of notional outstandings does not shed much light on this issue,” Richard Metcalf, head of policy for the International Swaps and Derivatives Association, observed in a letter to the U.K. Financial Services Authority last month.
Last December, the notional value of outstanding credit default swaps peaked at $67 trillion. Critics point out that amount was more than four times the value of all the bonds and other forms of corporate credit outstanding. And since those selling the contracts are by definition speculating, that means that at least three-fourths of the swaps were purchased by parties without an interest in the underlying debt the contracts were written against.
This would seem to pose a huge risk to the financial system. “When the notional value of a derivatives market is more than four times larger than the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging,” Lynn Stout, a law professor at UCLA, wrote in a recent issue of FinReg21, a website devoted to financial regulatory reform. “And business history—including very recent history—shows derivatives speculation increases systemic risk.”
Defenders of naked swaps, however, say efforts to rein them in will hurt the capital markets.
“Such swaps provide liquidity to the credit default swap market, and active trading in that market provides economically useful data in the form of prices for credit protection with respect to specific companies,” Randy Snook, executive vice president of the Securities Industry and Financial Markets Association, testified before the House Financial Services Committee last week.
Critics counter there is no evidence for such claims. To the contrary, they contend that speculators in swaps absorb—rather than create—liquidity by seeking to put up as little cash as possible in return. “The need for speculators to facilitate markets contrasts with recent experience where they were users rather than providers of scarce liquidity and amplified systemic risks,” Satyajit Das, a risk consultant, wrote on a website operated by Wilmott, a quantitative financial consulting firm.
And Das and others say pricing in the market is hugely unreliable. The Department of Justice started an anti-trust inquiry last week into a widely used pricing system for swaps that banks control.
Still, some supporters of the idea of distinguishing speculation from hedging concede that a ban on naked swaps may be tough to enforce. In a recent interview, Kurt Schacht, a member of the IWG and the managing director of the CFA Institute’s Centre for Financial Market Integrity, noted that he fully expected credit default dealers to get lawyers to write contracts that met the letter—but not the spirit—of the restriction.
Schacht said that the disclosure of the terms of such transactions to regulators, as the IWG report calls for, would still be useful, since it would provide them with a clearer idea of just how much speculation was going on.
Former CFTC chairman Born said that she thought the report’s other recommendations for stronger OTC market oversight, including tighter limits on margin borrowing and higher capital requirements for dealers, would also serve to restrain systemic risk. Those recommendations are indeed part of the Obama administration’s plans as well.
Born also said she was keeping an open mind on the issue of OTC derivatives in anticipation of the special commission’s hearings, which are scheduled to conclude with a report by the end of next year.
Nevertheless, some critics doubt that measures to limit the leverage and increase the capital involved in such transactions will be effective without a limit on speculation. Why? Because the inherent illiquidity of the credit default market makes it impossible to anticipate the collateral required to back them when defaults occur.
“Collateral models are based on historical volatility that may underestimate risk,” Das wrote.
Thus, he insisted that any meaningful regulatory reform must impose a distinction between speculation and hedging. He labeled the lack of such a provision in President Obama plan’s “a central omission.”
UCLA’s Stout also notes that, before the laws were eased under the Clinton Administration, courts had no difficulty enforcing a distinction between hedging and speculation under state gaming laws. This prompted speculators in derivatives, once known as “difference contracts,” to make sure that their counterparties could make good on their bets by developing exchanges, along with margin limits and capital requirements for participants, on their own.
As she put it in her piece on FinReg21, “the old common law rule against difference contracts was a simple, elegant legal sieve that separated useful hedging contracts from purely speculative wagers, protecting the first and declining to enforce the second. This approach kept runaway speculation from adding intolerable risk to the financial system. And it didn’t cost a penny of taxpayer money.”
At last count, the AIG bail-out had cost taxpayers $180 billion.
 |
in CFO Conversations by 
Subscribe to this comment's feed
