Banks Still Not Ready to Give In on Derivatives

A week or so ago it looked like everyone was on board with the plan to put most derivatives into a central clearinghouse and allow certain bespoke contracts to be traded outside of it but with disclosure. Well, guess what? The big banks are working behind the scenes to alter things. You didn’t think it was going to be this easy did you?

From the WSJ:

A group of banks and money managers will next week present a plan designed to help fend off some rules proposed by the Obama administration, which is seeking to control trading in the opaque market for over-the-counter derivatives.

Earlier this month, the U.S. proposed giving the Securities and Exchange Commission and the Commodity Futures Trading Commission authority to mandate centralized clearing of certain derivatives, impose new trade-reporting requirements, and force trading of “standardized” contracts onto exchanges or electronic platforms that will make prices more transparent.

Wall Street banks with large derivative-trading businesses have been outwardly supportive of greater regulatory oversight of the $684 trillion market. But behind the scenes, there has been hand-wringing over the details of certain proposals and discussions about how the industry can help shape the rules.

Potentially billions of dollars in revenue is at stake. An effort earlier this decade to improve transparency in the corporate-bond market ended up cutting bank fees by more than $1 billion in a year, according to some studies.

In the letter, expected to be released next week, the banks will reiterate a commitment to meet the government’s goal of transparency.

The industry will detail plans to expand central clearing of credit-default swaps to investment funds and other market participants. It also will propose that customized credit derivatives like those that nearly brought down American International Group Inc. be reported to a trade-information warehouse run by Depository Trust & Clearing Corp. On Thursday, DTCC moved to have its warehouse overseen by the Federal Reserve as it seeks to align itself with regulators’ goals.

So far, some regulators and politicians are holding a hard line, insisting that radical changes are needed to avoid a repeat of last year’s market panic when large financial firms neared collapse and no one knew how linked they were to others through derivatives. The reforms also mean that “the days of conducting standardized derivative trades over the phone will soon be over,” said one senior administration official.

It’s too soon to get all lathered up about this. Plenty of time for that once we see the proposal but forewarned is forearmed. I suspect that little good will come of all of this.

I’ll reiterate my position. I do not think that anyone understands these instruments well enough to have them exist in any form other than one that transmits the maximum amount of information to the regulators and public. Clearly, this is a narrow market with risk highly concentrated in a few financial institutions. With experience and more understanding it might be entirely possible to allow them to be created and traded both on and off an exchange. The preferred method of arriving at that point should be one that entails working backwards from full regulation.

Comments

[Hurricane:]

I am familiar with a pricing service in the '80s - when CMOs traded "by appointment only." Only one brokerage handled most of the trading . Then, as now, no one really knew what they were worth. The creator's models hadn't been tested for extreme redemptions when interest rates fell quickly, decreasing the duration of the underlying securities and hence the value of the CMOs. The packager of the CMO's, recently swallowed by a bank, was embarrassed to the tune of several hundred million.
Models still are just that - models - whether they "predict" the weather or "determine" value. "Bespoke" instruments means "bespoke" models. Better multiple standard instruments that everyone understands (like leveraged and unleveraged, sector specific ETFs) and then work with a client to select the best fit to their needs. Like making change with quarters, dimes, nickles and pennies.

May 31 12:18 PM

[Ishortyou:]

most of those models did not considered extreme events like the fall of Lehman for example which cause a massive redemption on derivatives or contracts.

May 31 03:37 PM

[reluctantQuant:]

CDS: 80% of what trades is "cookie cutter stuff." The other 20% provides for the counterparties who want "custom fit suits." This is true of lots of markets.

Guess which part is most profitable, and which generates the fattest fees for the dealers?

These same 80/20 characteristics hold true for equity options markets. One can get the basic stuff through an exchange (listed puts & calls) or one can get something more exotic custom built by a dealer (path dependent, averaging, multi-legs).

The biggest problem wrought by CDS has been leverage. When an investor can take sizeable "naked" risk in credit and rates with relatively little INITIAL collateral... well, we all read the papers (and own a little AIG as taxpayers).

The exchange concept provides one central view on players' aggregated exposure. Daily central collateral netting and open interest monitoring by a third party provides ongoing stability. Think about why the Amaranth debacle, multiples of the LTC mess, didn't disturb a single bank too much.

Let the OTC folks do their deals, give them a nasty haircut against capital, put the cookie cutter stuff on an exchange just like commodities and equity vanillas, and let's all send the lawyers and lobbyists home early.

--rq

Jun 01 08:32 AM