Over-Regulating Derivatives Dealers Could Increase Risk

In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily.

One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

Comments

[neutrino23:]

I'm skeptical of the many conditionals you invoke. Things may not work the way you think.

Jun 28 10:29 PM

[Michael Bla...:]

It's not *increasing* risk, it's *exposing* risk. Risk that was already there, but we pretended otherwise.

Hiding risk through complicated counter-party shenanigans isn’t “risk management.” It’s magical thinking that risk can be entirely removed. If a little “inefficiency” in risk management forces companies to adequately account for the risks they are taking, it’s "efficiency" we can do without.

This whole comment simply makes the argument that standardized contracts somehow cannot account for every little aspect of a deal. That's entirely correct. We should probably get rid of all standardized forms. I mean, students could probably get a loan for school without FAFSA, right? We'd probably all enjoy ditching the 1040 form at tax time for the 10-4ME where you tell the government what you made in whatever way is most efficient for you. And geez louise, who needs a Uniform Residential Loan Application. I mean, we'll all be better off if lenders can use whatever form they like, because CLEARLY they only act in the best interests of everyone and not their own bonuses.

Yes, standardized forms decrease efficiency, but in a market as large as the financial derivatives market (in the quadrillions now, worldwide, i.e. easier to write in scientific notation), they serve the purposes of simplicity and transparency. The OTC ("custom") derivatives market EXPLODED in the last five years, and the result was "risk management" in name only, as no one was able to grasp the systemic risk being created in the web of counter-parties. The only way to get that systemic view is to drive anything that CAN be done using standardized instruments to do so. Such instruments can be easily aggregated and thus systemically analyzed. There will always be a niche for OTC derivatives, but when the purpose of going OTC is to occlude inspection, that's not efficiency, it's cheating.

Jul 06 04:33 PM