Print this article | Return to Article | Return to

Reforming Derivatives: Naked Fear

Tougher rules are needed but may go too far.
Economist Staff, The Economist
August 6, 2009

Tim Geithner has reportedly grown so exasperated with uncooperative regulators that he recently blasted them with an expletive-filled rant. Yet the American treasury secretary's worker ants continue to draft financial reforms as if nothing were amiss. The next and last proposal to be sent to Congress, any day now, covers the $590 trillion market for over-the-counter derivatives, with particular emphasis on the credit-default swaps (CDSs) that humbled American International Group. Once lauded as a way of offering protection against the risk of companies defaulting, CDSs instead magnified uncertainty as buyers wondered whether sellers could really afford to pay up if called on.

The Treasury's proposals are expected to echo a plan put forward by congressional committees on July 30 - with at least one key difference. There is broad agreement that "standardized" CDSs should go through a central clearing house, in order to reduce systemic risk when counterparties fail. If possible they should also be traded on exchanges. To encourage migration to these platforms, contracts that remain privately traded will incur much higher capital and margin charges. All market participants will have to disclose more to regulators about their positions.

Derivatives dealers can live with these changes. In contrast to the Treasury's probable plan, however, congressional leaders have also left open the possibility of banning "naked" CDSs (in which the buyer of protection does not own the underlying bond). The impact of prohibition could be dramatic: up to 80% of CDSs are thought to be naked. Marketmakers say a ban would make it harder for them to offset risks, since speculative buyers are a big source of liquidity. That could, in turn, raise borrowing costs for bond issuers, says Tim Backshall of Credit Derivatives Research.

Even if this measure is sidestepped, there are plenty of other devils in the detail. How much of the market should be "standardized"? Reducing the scope for bespoke products would make hedging more difficult for airlines, manufacturers, and oil producers as well as banks. Should the number of clearing houses-which have sprouted on both sides of the Atlantic-be limited? A monopoly would be unhealthy, a multiplicity inefficient (since netting would be harder). And who will regulate what? The Securities and Exchange Commission and the Commodity Futures Trading Commission (CFTC) will oversee contracts based on securities and commodities, respectively, but some swaps straddle both categories.

CDSs are not the only members of the derivatives hall of shame. The CFTC, emboldened by bubbles in oil and gas prices to fight "excessive speculation," this week wrapped up hearings that foreshadow position limits for futures traders in energy markets. Such limits would curb the number or value of contracts a trader could hold in a particular commodity and across relevant exchanges. A trader's intent is hard to pin down, however. Index funds, for instance, do not hold commodities themselves but passively invest their clients' money in energy derivatives to hedge against inflation. And their positions are in any case regularly dwarfed by those of supposedly genuine hedgers, says Kamal Naqvi of Credit Suisse. Market insiders reckon that firms such as Shell and Lufthansa routinely trade more than their commercial needs would justify.

Position limits could also siphon liquidity away from American energy exchanges. At least one large dealer is already developing products to get around the CFTC's impending changes. That would undermine the overall goal of the Treasury's reforms. But lawmakers are not in the mood for half-measures. As Collin Peterson, head of a congressional committee that oversees derivatives, put it recently: "We clearly want to err on the side of too much regulation rather than too little, given what we've been through."