Finance Cannot Be Controlled

by: John M. Mason

Philip Stafford writes in the Financial Times,

"The theory behind the post-crisis regulatory overhaul of derivatives trading is about to become practice and concerns are growing that systemic risk will simply be transferred rather than backstopped."

He concludes his article by quoting David Clark, chairman of the Wholesale Markets Brokers' Association:

"Every regulation we've seen has the unintended consequence of increasing the exposure to the non-bank sector, and collateralization is one aspect of that. It potentially increases systemic risk. It's going to be very difficult for regulators to get into the non-bank sector to assess risk."

That darn "non-bank sector"!

The particular concern addressed by Stafford in this article is the collateralization concern. Global regulators, after the collapse of Lehman Brothers in 2008, have pushed for derivatives trades to be backed by collateral "to give counterparties more assurance about their trades in a default."

The regulators preferred answer to this concern is to have the risk management of these trades transferred to a clearing house rather than have trading take place over-the-counter. The problem is the source of the collateral to back up the trades. The preferred source of the high-quality collateral is cash or US government bonds. Clearing houses would accept this collateral before accepting trades.

The problem is that "overlapping regulation for the banking and derivatives markets is helping transfer risk into the more lightly regulated "shadow banking" market-the area the rules were supposed to rein in."

Just as the leverage ratios of banks are going down, the financing needs of the market are increasing. New sources of cash are needed. And, these new sources of cash are forthcoming.

The "new" sources are hedge funds and pension funds and insurance companies and non-financial corporations.

At December 31, 2012, banks and broker dealers, the perceived major source of collateral provided only 23 percent of the collateral agreements on record. Mutual funds provided 28 percent of the collateral agreements while hedge funds provided 17 percent. Insurance companies and pension funds provided just under 10 percent and non-financial corporations added another 7 percent. Almost 16 percent came from "other" sources.

Central banks, according to Stafford, have wanted the "market" to come up with its own solution to any collateral shortage that might exist. This is where, however, the clash with the other rules and regulations that have been devised since the financial crisis come into play and result in a default of the banking sector to the non-bank sector.

"Market infrastructure providers like clearing and settlement houses and institutional investors are positioning themselves as intermediaries, either to reinvest cash or helping to transform low-quality collateral through their own repo and securities lending operations."

One arrangement that is arising is the "tri-party" collateral space. Where corporations and buyside investors are participating in the repo market and this is "changing the industry."

More and more of the business of finance is being pushed into the "shadow" side of banking because of aggressive regulation and regulators and because of the avenues that are opening up through the greater application of information technology.

According to the information provided, since 2008, way more than half of the global value of collateral is not being reported through official channels… these collateral values can only be estimated. And, if the trend continues, more than two-thirds of all collateral value will occur in non-reported form.

As the regulatory effort has aggressively pushed forward in the last four years I have constantly suggested that financial institutions are way out in advance of the regulations and the regulators and we probably won't know all the ramifications of the spread of "shadow banking" until the next crisis occurs.

Remember: finance is just information. Information can be "sliced and diced" in many, many ways because information is just 0s and 1s. And, history has shown that the spread of information cannot be controlled… the spread can only be delayed or re-channeled. This is something that governments and regulators have not fully comprehended yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.