Regulating Derivatives: Easier Said than Done

by: Matthew Goldstein

The key to the Obama administration’s plan to bring order to the murky world of derivatives ultimately rests on the definition of what is a standard run-of-the mill derivative.

That’s because Team Obama wants the vast majority of derivatives — financial instruments that derive their value from an underlying stock, bond or other asset — to get traded on regulated and well-capitalized exchanges and clearing houses.

So there’s an incentive for regulators to force banks to classify as many derivatives as possible as plain vanilla transactions. But in the nearly two months since the financial regulatory overhaul was proposed, no one has come up with a workable definition for distinguishing a standard derivative from a customized one — essentially an untradeable, one-off transaction.

Treasury Secretary Timothy Geithner has promised that the administration will propose a broad definition of a standard derivative that will be difficult for banks to “evade” by putting so many bells and whistles on a transaction that it becomes a non-standard derivative.

But so far he’s offered nothing.

I hope Geithner does better at coming up with a definition for a standard derivative than former U.S. Supreme Court Justice Potter Stewart did in 1964 for deciding whether a movie or book was pornographic. Back then, Stewart famously said about pornography: “I know it when I see it.”

The Stewart approach, however, didn’t work well for sorting out the constitutionality of various state obscenity laws. And it certainly won’t work with derivatives, where even the bankers who create these exotic financial instruments often can’t come to an agreement on what separates a plain vanilla derivative from a more unique transaction.

The trouble is I’m not sure if it’s even possible to come up with a workable definition.

Take a look at the so-called Level 3 analysis that banks are required to do for any hard-to-value or hard-to-trade asset on a bank’s balance sheet. At first blush, you would think that a non-standard derivative automatically would be classified as a Level 3 asset based on its uniqueness and limited ability to be traded.

But that’s not necessarily so, say bankers familiar with derivatives.

In fact, a lot of derivatives that banks classify as a Level 3 asset get the hard-to-value treatment because of uncertainty about the value and “price certainty” of the underlying asset that the derivative relates to.

JPMorgan Chase (NYSE:JPM), in the first quarter, moved a $17.7 billion credit default swap out of its Level 3 bin because the underlying security that this insurance-like derivative provided default protection against had become better able to price. And it’s not uncommon for derivatives that were once easier to value to suddenly become impossible to value and trade based on changing market conditions.

This then begs the question of whether a derivative can one day be classified as a standard financial instrument and because of changing market trends, later be reclassified by a bank as a non-standard deal?

I don’t know the answer to this question. But it’s another illustration of how regulating derivatives may be easier said then done.