Bankers, erstwhile masters of the financial universe, are not used to being spoken down to. But just days after the industry resolved, in the words of Deutsche Bank’s Josef Ackermann, to “clear our house first and not leave it to the regulators to do it for us”, the Group of Seven finance ministers made it clear that they took such resolutions with a pinch of salt—and vowed to oversee the spring-cleaning themselves.
Reports from the IMF, the Financial Stability Forum, the Basel Committee on Banking Supervision and other august bodies have drawn attention in the past week to the appalling risk-management by many banks before the credit crisis. That is almost bound to mean tighter capital standards and tougher supervision. Quite right, given that the authorities have gone to extraordinary lengths to bail the banks out. More problematic, though, is the G7’s focus on the market for financial derivatives traded off-exchange. These are the volatile instruments that, had Bear Stearns collapsed, could have brought down the financial system with it. Given their fissile nature, it is no wonder regulators are keen to simplify and standardise them. They would be wise, however, to tread carefully.
It is not hard to picture derivatives as a central battleground between banks and their regulators. For bankers, the ability to create specialised products for their clients, sold over-the-counter (OTC) like a tailored suit, is not only a fabulous source of fees. It is also a product of what some of them like to call their “intellectual capital” — which is far cheaper than the stuff on their balance sheets, especially now (see article). Clients seem to agree. Despite the crisis, the notional value of credit-default swaps, bedrock of a market for insuring against the risk of default, almost doubled last year, to $62 trillion.
After previous derivatives blow-ups in in the 1990s, banks fought hard to stop the business being herded onto lower-margin exchanges. This time the authorities may not be so sanguine. The swaps are mostly bespoke, traded between two parties (who often offset the risk by trading with third parties, and so on) and would have been subject to huge counterparty risk if, say, a big dealer like Bear Stearns had collapsed. They may sound sophisticated, but their settlement can be anything but (many contracts are still buzzed by fax from a buyer to a seller for signing). Three years ago, financial supervisors in America and Europe obliged big banks to start clearing a huge backlog in unconfirmed swaps contracts, fearing a legal quagmire if a lot of them needed to be exercised at once.
The radical solution is to take the unwanted complexity out of derivatives by forcing them onto exchanges. In an ideal world, that would make for more standardised products that enjoy more liquidity, easier valuations, less risk of legal challenge and more transparency. If you trade swaps like futures, the risk of any trading partner collapsing becomes far less acute; the exchange is the counterparty, and it has the job of monitoring the creditworthiness of the buyers and the sellers.
So far, so simple. But the world of credit is not ideal — especially now. To be useful hedges, swaps need to have a degree of specialisation. Fixed-income contracts can often be more than $1m in size, which means they are not easy to trade widely. There is no guarantee that an exchange-traded contract would be a liquid one. Far better, then, to let the exchanges themselves muscle in on the OTC market when they see an opportunity, grabbing contracts when they can offer greater liquidity, transparency and trust than private parties.
Instead of squashing the market, regulators should continue to encourage efforts to standardise the central clearing of contracts — the messy hinterland where so many of the counterparty problems fester. More automation and standardisation of documents would help minimise potential disputes. It would speed up the process between execution and settlement. And if there is foot-dragging by the banks, the authorities could spur things along by requiring them to post more capital against contracts where there is a risk that a counterparty will go bust. Armed with their brooms and pinnies, the regulators clearly can help to tidy up the OTC market. There is no need to sweep it out of existence.