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ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues each week in derivatiViews.

Disgusted, Tunbridge Wells

Letters to the editor are a common feature of most news publications. Often they are penned by outraged readers. Sometimes they are not. According to the BBC, staffers at the former Tunbridge Wells Advertiser wrote their own to fill space: “One [staffer] signed his simply ‘Disgusted, Tunbridge Wells’, and a legend was born.”

We note this because of a recent letter we came across in the Financial Times. It, too, appears to have been written by someone with an unusual sense of humor (though this time, no newspaper staffer or pseudonym is involved).

The FT letter is entitled “Fragmented derivatives market may cut global risk.” It’s written in response to an article about the lack of global coordination of derivatives regulations: “US rules ‘endanger’ derivatives reforms.”

So what’s the beef?

It’s this – the letter articulates the view that geographic fragmentation is a good thing:

“So, the global derivatives market could fragment along regional lines. That might be anathema for some – yet might make for a safer, less globally connected and also more constrained market… the mere decline in the extent and inter-regional connectedness of derivatives trading could make for less global risk.”

And it does so apparently because global reform is the brainchild of special interests:

“Until recently, ‘reform’ implied action in the public interest. However, the adoption and globalisation of the reform agenda by special interests merits a second glance…”

It would be great if the derivatives industry could take credit for the idea that markets are global, but we must give credit where it is due. It’s not a particularly new idea. But it is one espoused by global policymakers. As the 2009 G20 Pittsburgh Summit Communique stated:

“Continuing the revival in world trade and investment is essential to restoring global growth. It is imperative we stand together to fight against protectionism… We will keep markets open and free… We will not retreat into financial protectionism, particularly measures that constrain worldwide capital flows, especially to developing countries.”

Economic theory posits that globalization increases economic growth and reduces poverty. As a recent issue of The Economist stated:

“According to Amartya Sen, a Nobel-Prize winning economist, globalisation ‘has enriched the world scientifically and culturally, and benefited many people economically as well’. The United Nations has even predicted that the forces of globalisation may have the power to eradicate poverty in the 21st century.”

We think the benefits of global financial markets also accrue to users of derivatives. It enables counterparties who do not want a particular risk to more easily and more cheaply find someone better able to manage that risk. That could be the firm next door or the firm across the ocean.

If derivatives markets were not global, then that risk would be transferred to someone locally – or not at all.

In either case, the risk is likely to be less effectively managed. Which ultimately means that risk in the system might increase, rather than decrease, if markets are fragmented. And while that may not be a reason to be disgusted, it’s certainly a reason to be dismayed.