OTC No More: Blessing or Curse for Institutional Investors?

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 |  Includes: AIG, CME, ICE, NYX
by: Susan Mangiero, CFA

According to the Bank for International Settlements, the global over-the-counter ("OTC") derivatives market toppled $683.7 trillion as of June 2008. See "OTC derivatives market activity in the first half of 2008" (November 2008). It should come as no surprise then that hungry regulators have set their sights on this economic juggernaut. We're regulating almost everything else. Why should OTC instruments be any different?

Hot off the press, the U.S. Department of Treasury yesterday announced plans to regulate "all Over-The-Counter derivatives" with stated objectives that include:

  • Preventing activities within the OTC markets from posing risk to the financial system
  • Promoting efficiency and transparency within the OTC markets
  • Preventing market manipulation, fraud, and other market abuses
  • Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

This is not the first time that Washington has tried a D-word power grab. In May 2002, I wrote "Anyone up for OTC Derivatives Regulation?" in which I pondered whether more government intervention would help. (H.R. 4038, mandating derivatives market reform, did not survive a Congressional vote.) Quote me as saying that "Mandatory regulation comes with a hefty price tag. Compliance diverts resources that could be expended elsewhere on behalf of shareholders. The law of unintended consequences loom large and the 'one-size-fits-all' approach encourages adverse selection. This, in turn, rewards imprudent risk-taking and exacerbates problems associated with misuse."

In 1994, the International Association of Financial Engineers selected my student paper for presentation at their annual conference in New York City. Entitled "In Defense of a Free Financial Derivatives Market," I emphasized the costs of compliance and the oft-perverse aftermath, as countless organizations scramble to avoid regulatory problems by seeking loopholes. So far, few have disputed the factors I laid out then as expensive and therefore aptly deemed as "economic bads."

I'm not alone in believing that what I scribed then remains true today in terms of the many costs of regulation. The list includes:

  • The cost of compliance, related to regulatory recordkeeping
  • The cost associated with creating an asymmetry of market information
  • The cost of creating the problem of adverse selection by treating all risks as equal
  • The cost of abrogating the legal right of individuals to contract with agents and to own private property
  • The cost of making hedge management more difficult, and
  • The cost of stifling product innovation.

Was I prescient in 1994 and 2002? Perhaps but I think many could read the handwriting on the wall. What goes up must come down, right? After all, the topic du jour is whether any market or organization should be allowed to grow "too big to fail."

What does OTC derivative instrument regulation mean for pensions, endowments and foundations? One likely outcome is that the cost of hedging will go up at the same time that some institutional investors favor a more systematic approach to risk management. Will regulation make the world safer? Probably not. There is the danger that some will be lulled into complacency by equating more rules with less uncertainty.

I'd much prefer an effort to have OTC derivative buyers and sellers better assess and manage risks. As CPA Michael Jellison wrote in response to "U.S. Lays Out New Derivatives Rules" by Kara Scannell and Corey Boles (Wall Street Journal, May 13, 2009):

To the investor - if the instrument does not make intuitive sense to you on its face, stay away from it. That's the best form of regulation.

Touche!

Author's Note: Email your name and fax number if you would like a hard copy of "In Defense Of A Free Financial Derivatives Market" by Susan Mangiero, 1994. Some of the statistics are dated but the principles remain valid.