A Sensible Approach

We admit it. We like headlines like this one − It’s Time for Sensible Regulation of Derivatives – which we first came across on The Exchange, a Yahoo! Finance blog.

But as it’s a blog (like media.comment), we weren’t too excited – until we saw that one of the authors was Martin Neil Baily, former chairman of the US Council of Economic Advisors. Dr. Baily (who served in the Clinton Administration) and his co-authors (who served in the Obama Administration) support derivatives activities:

“The bulk of derivatives are interest rate swaps, credit default swaps on corporate bonds and municipal and state bonds, commodity price derivatives, and currency swaps. These markets did not break down in the crisis and did not contribute to it.”

The authors also support prudent derivatives regulation, and “want to get that regulation right.” They are concerned, though, about some aspects of regulatory reform.

“It is worth asking if the myriad of rules put into place in Dodd-Frank to regulate derivatives can work together effectively and coherently. Congress, and the Financial Stability Oversight Council, should ensure that the different regulatory bodies work together to craft consistent rules of the game. Tackle the problems that emerged in the derivatives market and improve the economy’s stability, while still reaping the economic benefits derivatives can and do provide.”

It stands to reason: to develop effective derivatives regulation, we need to accurately understand the problems we are trying to solve. What are those problems? As Dr. Baily noted last month in a Brookings Institution conference on the purposes, structure and regulation of the financial industry:

“I think derivatives maybe have been…overstated a bit in their influence on the crisis. Like many historical crises…the one we’ve been going through I think was fundamentally caused because financial institutions bought and held bad assets…”

He went on to note:

“…I don’t think derivatives are the main story and I think all derivatives should not necessarily be viewed as toxic as Buffett said…”

One of the major issues related to derivatives in the financial crisis, he said, was “We didn’t know enough about the derivatives that were out there, who was holding them, what the implications would be…there was a real lack of information.” This concern helped give rise to the establishment of trade repositories to which market participants report their transactions, providing regulators more and better and deeper transparency on exposures and activities than ever before. (The need for regulatory transparency is why we oppose fragmentation of trade reporting and repositories, as outlined in our recent letter.)

The other major issue noted by Dr. Baily was AIG’s credit default swaps. As we have written elsewhere, the AIG situation reflected a failure to adequately measure and manage liquidity and collateral requirements. Had a robust variation margin framework been in place, AIG’s bail-out likely would have been averted.

Sensible indeed.

Initial Thoughts on Initial Margin

A recent speech by the Federal Reserve Board’s Vice Chairman appeared to get the New Year off to an inauspicious start for OTC derivatives markets. Initial reports of the speech indicated that it called for tougher regulation and treatment of derivatives, including a requirement for initial margin.

Bah, humbug.

But then we actually read the transcript, and felt a little better. There are some key aspects to the speech that we agree with.

First, there’s recognition about the benefits of a robust variation margin (VM) framework and its role in achieving an important public policy goal:

“The [VM requirement] codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily. However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again [emphasis ours], since current exposures will not be allowed to build over time to unmanageable levels.”

Second, there’s acknowledgement of the impact that initial margin (IM) requirements will have on liquidity and on the cost and availability of OTC derivatives to end-users: “higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk.”

Another key point: the speech notes that “requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risk …” But that’s because the risk management practices of CCPs are not well-suited to manage such risks – and not because the risk of such instruments is unmanageable (for more on this, see our December letter to BCBS-IOSCO on Margin Requirements For Non-Centrally-Cleared Derivatives).

There are, to be sure, some points that we disagree with. And there are some that we really disagree with.

We don’t, for example, believe that IM will reduce systemic risk. If done improperly, it could actually be highly pro-cyclical and increase systemic risk.

And we also don’t see how margin requirements can “diminish the incentive to tinker with contract language as a way to evade clearing requirements.” This notion ‒ that IM is needed to enforce or incentivize clearing ‒ has taken hold in some circles to justify the imposition of IM, but we don’t think it lines up with the facts. Clearing has happened, is happening and will continue to happen because it is a cost-effective means of managing risk through standardized products.

As we stated in the letter to BCBS-IOSCO mentioned earlier: “If a transaction is not clearable, then no amount of IM can cause it to be cleared. If it is clearable, then legal mandates – and not punitive IM – should drive clearing. If a high level of IM is the tool used to try to incentivize clearing, not only would such a strategy fail, but there would be…. potential adverse ramifications.”

2013 looks like a year in which we will be talking a lot about margin requirements. We’re not sure if this will keep us merry and bright over the next 12 months, but it should keep us busy.