Time to Regulate Derivatives (like every other financial instrument)
What is it about derivatives that makes otherwise rational humans become so damned stupid? There is no need to over-complicate this; a rather simple series of steps can be undertaken to bring the most dangerous of derivatives out of the shadows and into light of day.
Radical derivative deregulation had a bastard birth: On the eve of a holiday break, Texas Senator Phil Graham attached a budget bill rider titled the Commodity Futures Modernization Act of 2000. This was done at the behest of his wife Wendy, who was a member of the Board of Directors of Enron.
What the CFMA did was create a unique financial product. Derivatives and Swaps entered a world where they were treated very differently from all other financial products. Stocks, bonds, options, futures all follow specific rules. Securitized derivative products (collaterallized paper such as CDOs, CMOs, CLOs, etc.) and Credit Default Swaps (CDSs) do not.
Consider for example these characteristics of most financial instruments:
-They trade on an exchange;
-Participants have sufficient capital to engage in trading;
-Counter-parties disclosure is known (at the least to the exchange)
-Potential future payments require capital reserves to meet obligations;
-The full amount of traded instruments is transparently disclosed;
-There is a regulator in charge of insuring the above rules are followed.
Derivatives had none of those. Indeed, the CFMA specifically exempted derivatives not only from these items, but added they were exempt from state insurance regulators.
Let’s not over-complicate this: We need to do 3 things to rein in the worst aspects of derivatives, and dramatically reduce the systemic risk they present, while retaining their ability to be a valid financial instrument for hedging risk:
1. Repeal the Commodity Futures Act of 2000
2. Treat Derivatives like all other financial instruments: All of the above elements need to be derivative requirements;
3. Give the Commodity Futures Trading Commission full oversight and the teeth to enforce the rules.
Wall Street and the banks will fight this tooth and nail, as they are reaping billions in derivative trading profits. Never mind that whole 2008-09 meltdown thingie — that’s ancient history.
This is simple, folks: Derivatives should not receive special treatment — they need to be regulated the way most other financial products in the world are.
>
See also:
Goldman Deal-Maker Now Advocates Regulation
GRAHAM BOWLEY
NYT, March 10, 2010
http://www.nytimes.com/2010/03/11/business/11cftc.html
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March 11th, 2010 at 7:52 am
lets not forget to terminate offsetting trades! as an “old” option trader, how would that look if all the trades stayed open? counterparty risk? a long, long row of dominos? as usual our esteemed government & legislators snuggle up to the wards of wall street and pretend not to see the elephant in the room.
March 11th, 2010 at 8:04 am
Consider for example these characteristics of most financial instruments:
-They trade on an exchange;
-Participants have sufficient capital to engage in trading;
-Counter-parties disclosure is known (at the least to the exchange)
-Potential future payments require capital reserves to meet obligations;
-The full amount of traded instruments is transparently disclosed;
-There is a regulator in charge of insuring the above rules are followed.
Derivatives had none of those.
~~
if “Derivatives” had those features, one wouldn’t have been able to, so artfully, rig the Building–for it’s controlled demolition.
Economy Ramp n’ Crash2.0
March 11th, 2010 at 8:11 am
“But regulation means government, and government reminds me of how we had to desegregate our schools, so I’m against it.” — The GOP.
March 11th, 2010 at 8:13 am
Do you mean regulate in the same way the SEC regulates naked short selling and insider trading – like not at all ?
Seriously though this type of article stinks of ignorance
The bulk of derivative transactions are futures and options which are already exchange traded.
The OTC market has evolved to satisfy the needs of customers because of the lack of flexibility of exchange traded products. Customers want to hedge their risks exactly, not trade something similar that creates more risks than it hedges.
The OTC interest rate derivative market copes with major events (such as Lehmans) without a hiccup – I notice you dont mention the details of ISDA documentation in your rant and how netting of off-setting risk happens automatically in the event of default. There is no real need to offset trades as it is effectively done legally anyway.
You also forgot to mention how the majority of OTC trades are now being cleared – read margined allready.
The market has already changed – the last thing needed is more pointless government regulation. AIG and others got into trouble because they didnt understand what they were doing and were running excessive leverage. Derivatives in general were in no way at fault. If you want to blame unmargined CDS trading then I agree – but that is a small subset of the derivatives landscape.
March 11th, 2010 at 8:15 am
SB
It should have been clear to you from the reference to Options and Futures (above) that they were already covered by extensive regulation.
What I was referring to are securitized (primarily collaterallized) derivatives such as CDOs, CMOs, along with Credit Default Swaps (CDSs). (I will clarify that above for the reading comprehension impaired)
As to your suggestion that we should leave well enough alone, well, its an absurdity. Your may be protecting your own profits, but you are doing so at taxpayer expense. That is unacceptable to me.
March 11th, 2010 at 8:22 am
Steven,
you should have stopped before you got to: “AIG and others got into trouble because they didnt understand what they were doing..”
before then, you had a nice defense of OTC Deriv.s going..
March 11th, 2010 at 8:27 am
For once I agree with MEH. In addition the hedge their risks exactly line is analogous to we have to pay these losers huge bonuses to keep them rationale.
March 11th, 2010 at 8:42 am
Steven,
“You also forgot to mention how the majority of OTC trades are now being cleared – read margined allready”
Factually incorrect probably by a factor of 10X.
Also, OTC derivatives have “super-senior status” They get paid even before any bond holders in the US.
March 11th, 2010 at 9:10 am
As of 2nd of March LCH.Clearnet (one of a number of otc derivative clearers) now clear $212 trillion of Interest Rate Swaps. This is anew process and growing quickly.
Last available figures are Jun 2009:
Total derivatives outstanding 604 trillion of which 49 trillion is fx based, 437 trillion is interest rate based (of which 341 are IRS) and 36 is CDS.
How exactly am I out by a factor of 10 ?
~~~
As to super senior status – no
ISDA documentation means that at a global counterparty to global counterparty level all transactions dealt under the ISDA master agreement are marked to market, cash flows are netted and the deals are cancelled. Residual amounts are treated as any unsecured creditor. MOst important is that receivers are unable to cherrypick and perhaps that is where you get the idea of super senior status.
The first major counterparty default I dealt with was Drexells – it all worked perfectly even then with no market ripples on the derivative side. SInce then the derivative market has gone through numerous counterparty events.
Unmargined CDS are the exception due to the fact that the ‘notional’ principal isnt really a notional amount but is in fact the amount of risk.
March 11th, 2010 at 9:17 am
great king rat: Is our children learning?
“The market has already changed – the last thing needed is more pointless government regulation. AIG and others got into trouble because they didnt understand what they were doing and were running excessive leverage. ”
Ha ha ha ha. Yeah, and look how well deregulating a handful of financial institutions regarding leverage worked out. And the tax payers should keep ponying up to these blackmailers while they learn the ropes of raking it in, too. Jokes on you, Americans.
March 11th, 2010 at 9:26 am
Barry,
Its not enough to analyze a problem’s source and propose a solution, we need to know how to get it actually fixed. Should we become more political and contact our representatives and senators? But you didn’t even want to testify there – which of course I understand – but how to get it fixed.
Seems like simple, clear explanations should have value, but it seems too that ethical standards are lower than in the past.
Thanks for the possibility spelled out succinctly.
March 11th, 2010 at 9:27 am
Off topic, but today’s dead tree version of Rupert’s Wall Street Urinal headline quotes Monty Python: “Excuse Me I Wish To Register A Complaint”
http://online.wsj.com/article/SB10001424052748704655004575113872190094934.html
Now THAT is one improvement over the Bancroft version….to
March 11th, 2010 at 9:34 am
What you mean here with the word “derivatives” is just too broad a term. ALL an “OTC Derivative” is, is a contract. Are you saying “lets regulate all contracts”? You cannot “regulate” something so broad… because regs are always situation specific.
Then you say… “like every other financial instrument”. But this is just a circular defination. “OTC” means “over-the-counter” or un-regulated, non-exchanged traded instrument. So the statement is simple a circle.
More specific ideas are more helpful:
The CDS (Credit Default Swaps) market has become broad, liquid, and uniform enough that it should be exchange traded and run through a clearing house. I believe this is already underway with the CFTC. Right?
Maybe someone should work on a interest-rate swap exchange and clearing house (although this hasnt really caused any problems)? What other areas are broad / large / uniform enough to warrant a push towards an exchange?
There will always be OTC contracts / derivatives that fit specific parties needs.
March 11th, 2010 at 9:38 am
Cognos:
Securitized derivative (collaterallized paper such as CDOs, CMOs, CLOs, etc.) and Credit Default Swaps (CDSs).
March 11th, 2010 at 9:48 am
The word clearing in an derivatives exchange has specific meaning. Futures and derivatives clearinghouses are machines that have the ability to go into bank accounts and take a huge amount of money whenever they feel like it. Every trades counter party is the clearinghouse. Every long is shorted by the clearing house, and every short is because the clearinghouse is long. This process is a totally different thing than when people talk about cleared in the OTC space. Literally, the OTC people do not know what they are talking about when they say “cleared”.
Clearing in the OTC space means “both back offices have verified the trade, and somebody is theorectially watching the margin, which may or may not be collected on a haphazard basis whenever one counterparty gets a bit worried or we want to drive AIG out of business”
This isn’t clearing. This is verification of a bilateral contract with some handwaving attached.
What threat did Goldman make to the U.S. Treasury? What specifically did they say? I wasn’t there but my $1000 is on “Well, if we don’t get paid, we’re not sure if we can pay JP Morgan for the swaps we have with them.” If OTC “clearing” was worthy of the name, this threat is the equivalent of a 5 year olds temper tantrum – and idle threat at best… But OTC clearing is not worthy of the name clearing.
JP Morgan is a big bank with a $92,000,000,000,000.00 unregulated, unsupervised, 1890′s vintage clearinghouse attached. They do not have a unified system like the CME or the ICE that allows them to look at everything in a few minutes. They have a hodgepodge of excel spreadsheets and best guess risk analysis, margins on products that haven’t been valued in months or years, a string of swaps that were offset by swaps with other counterparties, and an inability to easily get more money from their counterparties. In other words
So of course the Treasury coughed up 100% – they were worried about a mess that would probably push every developed countries back into the 1950′s and end capitalism literally forever.
March 11th, 2010 at 9:52 am
So the CDS market is already headed towards exchange trading, and fast I believe. It should’ve been done a few years ago. BUT this market is about 10-yrs old. So its just a maturation issue. It will reduce back-office work alot (and counterparty risk ambiguity a little).
CDOs, CMOs, CLOs and other forms of structured debt are harder. The structured debt market is VERY chunky. Its both non-uniform in terms / type of deals and then its non-traded. Its more like the traditional “bond” market. Which was never exchange traded for a simple obvious reason… size of trade was larger and lumpy. Thus “terms / instrument” and “size” and inexorably linked. That is, it trades in $100M to $1B+ lumps. So you cant really put that on an “exchange”.
Underneath those deals are just “contracts” — real estate finance, project finance, sub-debt private equity, etc. You cannot regulate ‘contracts”.
Maybe one could push for an exchange (and regulations) that covered some main vanilla traded mortgage products. From basic FNM/FRE passthrough trading. To some of the simple structure built around that (IOs, POs, options). To maybe incorporating some of the credit pieces (ABX tranches). Just get that stuff on a “mortgage exchange”. Thats a pretty healthy idea.
But I still think the drivers of the “crisis” of 2008 were much simpler — housing bubble, lax consumer protections on mortgages, lax bank regulators who didnt ask for higher-down payment (counter-cyclical thinking). NONE of these is really a worrisome issue going forward. (Ironically, capitalism needs regulations in the bubble but fixes itself AFTER).
March 11th, 2010 at 9:56 am
I didn’t realize the LCH had become so popular – I have a few friends there and as recently as a few years back they were lamenting their lack of progress on the product
March 11th, 2010 at 10:03 am
Mike S –
Clearinghouse CANNOT and DO NOT “go into bank accounts”. They hold margin. The call for more margin or they close your trade.
This is very similar to GS vis-a-vis AIG. GS held large collateral from AIG. They asked for more collateral (or would close trade) AIG did not want to post collateral — but also — did not want them to close trade. AIG shopped for better price (re-assign trade). Turns out GS price was BETTER than rest of market. AIG posted more collateral. Etc.
The tradgedy of AIG (beside the dumb-ass management) was that they became a forced unwinder at the bottom. Think about it, AIG probably lost $50B or more because they unwound swaps / contracts in Q4 2008. Today those contracts would be fine. Up 50-100% or more! These are simply the timeless facts of being overlevered into a crisis.
March 11th, 2010 at 10:13 am
I’ve concluded that unregulated derivatives are cancers that are too big to cut out. The cancer has undergone metastasis (with some $600-$700 trillion of these things in the world or so I’ve read). The Dr is left with a hard choice. Cut out the cancer (regulate) as best as possible, but if you operate the patient’s death is almost assured. So you sew up the patient, give them a few pain killers and maybe some miracle will happen.
Now we’re waiting on the miracle. Accounting now allows these assets (?)to be held on the books at some fantasy value. No new regulations that would expose this mess. Money (as in trillions TARP, stimulas etc) has been spent to keep things running best as possible. We’ve bought time that is all. In the meantime we wait for the miracle to happen.
March 11th, 2010 at 10:14 am
Cognos – “But I still think the drivers of the “crisis” of 2008 were much simpler — housing bubble, lax consumer protections on mortgages, lax bank regulators who didnt ask for higher-down payment (counter-cyclical thinking). NONE of these is really a worrisome issue going forward. (Ironically, capitalism needs regulations in the bubble but fixes itself AFTER).”
Lax lending standards were, at least in part, the product of the explosion in MBS activity. Securitization created a thirst for mortgage paper. Lax lending standards were also the result of the housing bubble. And part of the cause of the housing bubble. etc.
In other words, all of those things, INCLUDING the securitization and derivative aspects, drove the boom and bust.
March 11th, 2010 at 10:17 am
I can already see a bunch of red faced d-bags screaming -self-regulation-freedom-growth…
Nice reads from a great thinker.
http://www.pauljorion.com/blog_en/
March 11th, 2010 at 10:33 am
cognos,
Insurance policies are “just contracts,” but they are regulated. And the suggestion that BR is unwittingly saying “regulate all contracts” is just sophistry. Remember, the CFMA was designed to shield swaps from state insurance regulators — AIG FP would have had a very different business model were it not for this Act.
Moreover, you blithely mention “housing bubble” as a cause of the crisis. Well, golly geez, don’t you know that those unregulated CDS written by people like AIG played a huge role in the bubble itself? The ability to use (worthless) CDS in securitizing badly underwritten mortgages were the yin and yang of the housing bubble. It would have been much more difficult to turn junk into AAA without those CDS, and likely no one would have tried it if the swaps weren’t under-priced and inadequately capitalized. Now, if the CDS were actually viable and the sellers had adequate capital to pay them off, then no problem. But that’s not how it happened in many cases.
March 11th, 2010 at 10:50 am
clawback –
We had enormous amounts of MBS/derivatives/CDS innovation in 1992, 1995, 1998, 2001, 2003. What we didnt have was — large housing bubble. There is little reason to conflate “lack of derivative regulation” or “evil CDS” with the crisis of 2008. It was a Real-Estate bubble bursting. Very simple.
Insurance regulation DRIVES collateralized “AAA” derivatives and is not very effective. Can you say “biggest failure EVER” in AIG? This is a model to NOT follow.
March 11th, 2010 at 10:52 am
With all due respect: The derivative market is over 1.6 quadrillion. Is that regulatable? I mean given that this crap is already written and given that is like comparing the size of the sun to the earth?
March 11th, 2010 at 10:53 am
Barry you have reworded your article since I first read it.
If your problem is with tranched products of any description then I totally agree. Actually I would go further and ban them outright – It is completely impossible to price them becuase there are 2 un-knowable variables used in the pricing process – its a joke.
Your comment
Your may be protecting your own profits, but you are doing so at taxpayer expense. That is unacceptable to me.
My interbank derivative price making days are well behind me. I now work as a consultant training staff of the worlds major banks in derivatives and other wholesale financial products. None of the banks which are my major clients needed bailouts, and I would like to think that the scathing attacks on the whole CDO farce that I delivered to various risk departments before the crisis helped them in some small way avoid the products. I am not doing anything at taxpayer expense
March 11th, 2010 at 11:06 am
cognos, you’re usually cogent, at least. what are you saying? I’m not “conflat[ing]” CDS with 2008, I’m arguing for an important relationship between the two. You’re attempt at a historical comparison with earlier years doesn’t even make an argument. Have at it. I’m willing to admit I’m wrong, but nothing you’ve said here suggests it.
March 11th, 2010 at 11:07 am
‘your attempt’ ;-)
March 11th, 2010 at 11:46 am
IMHO, it won’t be a significative regulation in this matter.
Why ?? Simple , big profits , great price manipulation, great fee , big bonus , no tax , consumer design product-bets and specially Gvt. support in case TSHTF.
Guys , this is the best Casino ever and House always wins !!
The best regulation : LET THEM FAIL big time !! Defaulting ??? No money support !! NO MORE TOO BIG TO FAIL , THAT IS WHY THEY CAN FEEL FREE AND SAFE OF TAKING HUGE RISK : NO MORE SAFE NET !! !!
LET THEM FAIL !!! LET THEM FAIL !!
March 11th, 2010 at 12:13 pm
4> Throw Phil and Wendy Gramm in jail and confiscate all their assets, for their corruption and sabotage of any efforts to regulate derivatives over the past decade.
March 11th, 2010 at 12:13 pm
For those of us not in the world of finance, a question:
What the CFMA did was create a unique financial product. Derivatives and Swaps entered a world where they were treated very differently from all other financial products.
So does that mean CDOs, CDSs, etc. were previously regulated, but the CFMA removed those regulations by putting them into a new category?
Or were these products non-existent before the CFMA?
March 11th, 2010 at 12:39 pm
Credit derivatives in one form or another started trading in the late 80′s/early 90′s.
The CFMA simply provided legal clarity to the existing system of regulation of wholesale OTC derivatives. The CFTC and SEC had not previously had oversight of these products and for proper derivatives such as IRS nor should they
The issue in my opinion concerns securitised products such as CDO. These are not ‘derivatives’ in the true sense and to be honest should be treated as securities and regulated.
Product innovation happened faster than regulators could keep up with. The CFMA is not the ‘evil’ some people pretend it is.
March 11th, 2010 at 12:47 pm
Regulate AND tax them. When used for legitimate hedging a risk you are facing they serve a positive purpose. When used as a way to speculate and profit they are destructive. With a good little progressive tax, we can ensure that the speculators are kept out without shutting the whole thing down.
March 11th, 2010 at 12:59 pm
We should also repeal ‘Saint’ Phil Gramm’s Gramm-Leach-Bliley Act: allowing commercial banks, investment banks, and insurers to merge (which would have violated antitrust laws under Glass-Steagall), which also contributed to the mess.
MikeG’s sentiments are appropriate. Phil Gramm should be publicly electrocuted, and then shot.
Between his CFMA and Gramm-Leach BS, he deserves most of the (dis)credit.
March 11th, 2010 at 1:08 pm
cognos,
Not to pile on here, but if memory serves, you favored the AIG bailout as a necessary evil to save the financial system, etc. If so, then weren’t unregulated and/or fraudulent CDS at the heart of the financial crisis? I’m just failing to see how it all hangs together such that unregulated CDS can be deemed “not a problem”. See, if CDS had been regulated much the same way that life insurance is regulated, then AIG would have most likely had the ability to make good on its obligations without taxpayer money. As far as I know, no one needed a taxpayer bailout to make good on their bets in pork bellies.
March 11th, 2010 at 1:15 pm
[...] Barry Ritholtz, “This is simple, folks: Derivatives should not receive special treatment — they need to be regulated the way most other financial products in the world are.” (Big Picture) [...]
March 11th, 2010 at 1:42 pm
Dedude –
All a “derivative” is… take a swap… is a contract. Its just “I’ll pay you A-B, if you agree to pay me B-C”… in 1-yr. We dont regulate contracts. We really cannot.
Of course we can regulate exchanges and exchange-traded instruments. We can regulate banks (although again, not at the “every contract” level). But we cannot regulate business-to-business contracts. Its non-sense.
We mostly tend to regulate consumer financial contracts — credit cards, mortgages, stocks/bonds, insurance are all regulated as PRODUCTS sold to the CONSUMER. In a sophisticated business sense, they are unregulated.
For example, private venture capital “equity” is unregulated, right? Re-insurance contracts are unregulated. Swaps between hedge funds and banks are unregulated. These are just sophisticated “contracts” or “business deals”.
You want to regulate ALL business deals?
March 11th, 2010 at 2:02 pm
Any activity that has the potential to hurt “we the people” or hurt any individual person should be regulated by “we the people”. The absurd idea that somehow businesses are really smart and would not do anything that could hurt themselves or their investors have been debunked – so lets get on with the next logic step. All contracts are regulated by contract law, so it’s not like we are introducing a new and foreign concept.
March 11th, 2010 at 2:09 pm
“You want to regulate ALL business deals?”
This question has been answered already. The idea that regulation of certain credit derivatives means regulating “ALL business deals” is a complete non sequitor. All an insurance policy is….is a contract. We do regulate contracts. We really can.
cognos, you’re obviously frustrated by calls for regulation of certain derivatives, but what you’re saying just makes no sense.
March 11th, 2010 at 4:00 pm
[...] Posted by Steven Russolillo on March 11, 2010 Economy, Markets FusionIQ CEO Barry Ritholtz says it’s time to regulate derivatives just like all other financial [...]
March 11th, 2010 at 4:28 pm
Barry, thank you for the basic, clear explanation of what needs to be done with derivatives. I’m sure it’s far more complicated than this, but this succinctly explains the basic principles of what needs to be done.
Like most Americans, I have no idea about derivatives and this stuff, so it’s easy to pull the wool over our eyes. All I know is that I’m PO’ed, as well as almost everyone else, about how this crap caused this Great Recession.
I’m still shocked at, from your posts and from Niall Ferguson’s History of Economics TV special, that the total world GNP is like 43 Trillion, the peak of world stock market capitalizations was like 90 Trillion, and there were like 600 Trillion of options and derivatives written on this. And the majority of these derivatives were hidden from public and (non) regulator’s view. Wow!
I’m also struck by the argument being made in these posts that the government can’t regulate derivative contracts. Last time I looked, our Constitution had a Commerce Clause : “The clause states that the United States Congress shall have power “To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes”. ” The basic Securities Act of 1933 was based on this clause, and it’s been upheld by our courts for most of a century. I don’t understand how people can even make the argument that derivatives aren’t able to be regulated with a straight face.
March 11th, 2010 at 5:02 pm
Cognos said: “But we cannot regulate business-to-business contracts. Its (sic) non-sense (sic.)”
The Restatement (Second) of Contracts says a contract is: “…a promise or a set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty.” Read a few casebooks on Contracts and you may want to rethink your position vis-a-vis the ability of the law to deal with “business-to-business” contracts. Good luck with that argument.
Best regards,
RF
March 11th, 2010 at 5:34 pm
@cognos: “All a “derivative” is… take a swap… is a contract. Its just “I’ll pay you A-B, if you agree to pay me B-C”… in 1-yr. We dont regulate contracts. We really cannot.”
Um, do you actually buy any options? Its a contract where I pay someone a premium and they agree to pay me at expiration. Those are regulated just fine.
March 11th, 2010 at 9:30 pm
Goldman Deal-Maker Now Advocates Regulation
http://www.nytimes.com/2010/03/11/business/11cftc.html
Good read on re-regulating Derivatives (OTC).
March 11th, 2010 at 11:49 pm
[...] sur le lien) -Ajoutons à cela le grain de sel de Big Picture: http://www.ritholtz.com/blog/2010/03/time-to-regulate-derivatives/ (cliquez sur le [...]