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OTC Derivative Regulation Proposals – Neat, Plausible and Wrong!

Proposals for over-the-counter (OTC) derivative regulations are consistent with H. L. Mencken’s proposition that: “there is always a well-known solution to every human problem--neat, plausible, and wrong.”

A central omission is the speculative use of derivatives. Industry lobbyists focus on the use of derivatives to hedge and manage risk promoting investment and capital formation. While derivatives can play this role, the primary use of derivatives now is manufacturing risk and creating leverage.

Derivative volumes are inconsistent with “pure” risk transfer. In the credit default swap market (CDS) market, volumes were in excess of four times outstanding underlying bonds and loans. The need for speculators to facilitate markets contrasts with recent experience where they were users rather than providers of scarce liquidity and amplified systemic risks.

Relatively simple derivative products provide ample scope for risk transfer. It is not clear why increasingly complex and opaque products are needed other than to increase risk and leverage as well as circumvent investment restrictions, bank capital rules, securities and tax legislation.

A central reform proposed is the central clearing house (the central counterparty - CCP) where (so far unspecified) “standardised” derivatives transactions must be transferred to an entity that will guarantee performance.

The CCP centralises all performance in a single entity, surely the ultimate case of “too big to fail”. Effectiveness of the CCP depends on its ability to manage risk through a system of daily cash margins to secure exposure under contracts. Failure to meet a margin call requires the CCP to close out the position and offset any losses against existing collateral.

The level of initial collateral posted must cover the fall in value from the last margin call. There are inherent moral hazards in setting the initial collateral. Traders want the maximum amount of leverage by reducing the amount cash posted.

Collateral models are based on historical volatility that may underestimate risk. For some products, such as CDS contracts, establishing the required levels of collateral required is difficult. Cross margining where traders can net all open positions expose the CCP to correlation problems in the offset methodologies. Additional problems may arise from the use of multiple CCPs.

There are significant issues in pricing and valuing contract and, for some products, reliance on complex models. The CCP assumes the ability to value contracts that relies, in turn, on liquid markets in the instruments, an unrealistic condition as events have showed.

Mis-selling of “unsuitable”derivative products to investors and corporations remains a problem. Expertise of purchasers is sometime inversely related to the complexity of derivative products. Given significant information and knowledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should have been considered.

Complex risk relationships created by derivatives are not addressed. AIG’s problems related to margin calls based on current “market” values on its derivative contracts. The CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources.

Systemic effects, such as the impact of CDS contracts on risk taking behaviour and also dealing with financial distress, are ignored. Concentrated market structures, where a handful of large dealers dominate dealing, are also not addressed.

For example, the OCC in the U.S. reported that largest five banks hold 96% of total notional volume of derivatives and the largest 25 banks hold nearly 100%.

Familiar dictums - improved disclosure, transparency and operational processes - have been tried before with limited success.

The unpalatable reality that few, self interested industry participants are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.

Until regulators and legislators understand the central issues and are prepared to address them, no meaningful reform in the control of derivative trading will be possible.

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).