Catching Up On OTC Derivatives Reform
By Ivy Schmerken
Nov 11, 2009 at 10:20 AM ET
I've been catching up on my reading about OTC derivatives reform bills that were passed by the House Financial services and Agricultural committees last month. Though I am a little behind, I've concluded that not much has changed except that regulators really want to mandate clearing and trading on exchanges (or alternative swap execution facilities) to bring transparency into the market and save taxpayers a fortune from bailing out the banks again. At the same time, industry participants are worried about unintended consequences of these reforms.
But if you haven't been following the debate, here's a bit of a recap and an update on recent developments.
A few weeks ago, sources told me that mandatory clearing of standardized instruments and trading on exchanges was not certain. I heard that Congress would not insist upon mandatory clearing and trading on exchanges, because lawmakers realized that certain bespoke OTC derivatives lacked liquidity, were not standardized and would be difficult to price each day. Also the clearinghouse has to offset its risk through netting of positions, so submitting non-standard OTC derivative structures into the clearing entity could make it more risky since the clearinghouse would have these OTC structures left on its books. And then sources told me that Congress would let the clearinghouses (owned by the major dealers) decide which instruments were clearable, suggesting that it knew the dealers were more knowledgeable and experienced about derivatives than lawmakers. I thought this sounded strange, as if Congress was letting the dealers drive reform; it turns out, I was right.
Last week, Rep. Barney Frank, democrat Massachusetts who heads the House Financial Services Committee, said that he agrees with CFTC Chairman Gary Gensler that regulators-the SEC and CFTC- should decide whether an OTC derivative instrument is clearable. In a letter, Frank said he's concerned that since dealers own stakes in the clearinghouse, they have a conflict-of-interest.
Frank issued a statement in response to a letter from Gensler: "I appreciate Chairman Gensler's agreeing that we should change the provision of the derivatives bill that he requested that would have put the clearinghouses in charge of determining that a trade is clearable. As some people pointed out, this could have given rise to a conflict of interest, given the financial stake that many firms have in the ownership of clearinghouses," said Frank.
Originally, Gensler said leaving that decision to the CFTC would be burdensome for the regulator, but he has had a change of heart, too. I wonder what precipitated these changing views? Perhaps after all those meetings with industry lobbyists, Wall Street executives, SIFMA and corporate users of the products, asking for exemptions from posting margin, capital and collateral, Frank felt that there were too many loopholes and exemptions. He probably heard from Obama officials reminding him that this was their chance to implement sweeping financial reforms.
Gensler, who is no stranger to Wall Street since he worked at Goldman Sachs, has made numerous speeches about OTC derivatives regulation. One recent speech was at the Futures Industry Association Annual Expo on Oct. 21. "To reduce systemic risk, it is critical that we move all standard swaps off the books of large financial institutions and into well-regulated clearinghouses," said Gensler in his FIA speech, which is sponsored by exchanges that stand to gain from moving OTC derivatives onto their marketplaces.
In this link to a video interview with the Huffington Post YouTube, Gensler explains there are gaps in OTC derivatives regulation and why he thinks they ought to be tightened. One of the major reasons is that while the financial system has stabilized, it is highly concentrated in fewer large banks.
Gensler wants Congress to mandate clearing for all standardized contracts and trading on exchanges or swap execution facilities for standard contracts between dealers and their biggest customers. That would make OTC derivatives more futures-like.
He also wants to reduce the exemptions for commercial hedgers, such as airlines and farmers that use these products to hedge risk. "We want to make sure that all the corporations and users post margin and if they post margin that all that money is protected if a dealer goes bankrupt," said Gensler in the video interview, posted on YouTube. In his FIA speech, Gensler said to accommodate end-users' concerns regarding margin, they should be permitted to enter into individualized credit arrangements with the clearing members (dealers) that transact on their behalf. And he indicated that regulators would not require a particular form of collateral so he showed some flexibility in letting end-users work with the clearing firm to determine the type of collateral.
Meanwhile, corporate executives from airlines and drug companies testified before Congress as to why OTC derivatives were valuable for hedging against energy prices, foreign exchange and interest rates and to explain that their costs would go up if they had to post margin and collateral at a clearinghouse. They asked for exemptions from the margin requirements.
But Gensler is right about exemptions, if end-users receive too many exemptions or if they are too wide, then OTC derivatives won't be subject to regulation, they'll remain opaque and then nothing will have changed. "If Congress decides to exempt end-users from a clearing requirement, that exception should be very narrowly defined to include only nonfinancial entities that use swaps as an incidental part of their business to hedge actual commercial risks," Gensler said at his FIA speech. I do not believe that hedge funds, financial firms or other investment funds should be exempted from a clearing requirement," he told the FIA attendees.
I've spoken to several industry executives who are worried about "unintended consequences" for these corporate users who mainly use OTC derivatives in the interest rate and FX space. Bob Park, CEO of Fincad, a developer of analytics for OTC derivatives said that small and mid-size companies rely on the dealers for hedging their unique exposures with OTC derivatives. If they are forced to go to exchanges, their costs may rise since they will need to post margin and collateral and if they are forced to use futures, they risk having an incomplete hedge, said Park. "One of the problems of using exchange-traded derivatives is that they don't map precisely onto exposures," he said. "The approach that Congress is taking is really a blunt instrument," said Park in an interview. He also feels that Congress is trying to fix a problem that doesn't exist in derivatives, since most of the problems occurred in credit and mortgage derivatives. And so the OTC derivatives debate rages on. Stay tuned! It's going to be a bumpy ride.
