Thursday, March 4, 2010

Putting the adults in charge of derivative trades

Regulating Derivatives

Bringing more derivatives (i.e., like some standard interest rate and default swaps, some commodity hedges, etc.) onto exchanges makes sense. It would automatically enforce some formal margin requirements.

More importantly, it would shift the counterparty risk. Many algorithms for pricing derivatives ignore or poorly represent counterparty risk. There is no doubt that mismanagement of counterparty risk transmitted the crisis across markets. Further, concerns about counterparty risk necessitated the actions taken regarding AIG. Some people think the action was about AIG and its counterparties, but the systemic importance of the action wasn’t the event. Neither AIG’s size nor its web of relationships would have justified the action taken. At the time there was a mass realization that counterparty risk was being ignored or misrepresented. It was setting off a very real panic that became a significant contributor to a real risk of a total collapse. The action at AIG essentially established a finite limit to the system-wide liquidity collapse that counterparty risk could create.

Bringing as many derivatives as possible onto an exchange probably won’t be carried to excess. One would think that if the derivative doesn’t trade, the exchange wouldn’t want it. But, it is important that we remember that bringing derivatives onto an exchange doesn’t eliminate counterparty risk, it just shifts it. The markets need to be well capitalized. Margin requirements need to be strictly enforced and uniform across markets, preferably internationally.

Private deals could still be cut, but they’d be a smaller portion of the total. However, it is essential that all derivatives, even those traded over-the-counter, be backed explicitly by adequate collateral. Selling default insurance is the equivalent of selling naked puts. And, like selling naked puts, do it often enough and eventually you’ll get a collateral call. Nothing wreaked more havoc in the last few years than when traders woke-up and realized there was no collateral at all behind some derivatives and inadequate collateral behind many. Further, one of the reasons banks have found the private market for swaps so profitable is that regulators allowed them to do it without the level of capital the risk would justify. Offsetting positions aren’t a perfect substitute for collateral even in a smoothly functioning market much less under stress conditions.

The object shouldn’t be trying to develop the perfect balance between public markets and over-the-counter transactions. The objective is to reduce systemic risk. Simple steps and partial solutions can accomplish a lot.

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