Mondays always get me down

A decent weekend. Not much going on…

And then, on Monday morning, bam! Breaking news from The Wall Street Journal: “Big U.S. Banks Make Swaps A Foreign Affair”. The story basically posits that US banks are using their overseas affiliates to write some swaps with non-US counterparties without a parent company guarantee. This means that the transactions would not fall under the purview of US regulators.

Sounds troubling.

But as the infomercials say: Wait! There’s more!

A lot more.

First, the transactions would in fact fall under the purview of regulators in the jurisdictions in which they are done.

Second, on the major systemic risk issues (clearing, trade reporting, margining), there is likely to be little to no substantive difference between major jurisdictions.

So this clearly is not a case of regulatory arbitrage. It’s really about the fact that some customers do not want or have the capacity to understand and comply with regulations in two different jurisdictions. These non-US customers prefer doing business with non-US firms. They don’t want to trade on SEFs. So the US firms are structuring their businesses to meet this demand.

Most people know all of this, as the Journal article acknowledges.

So what’s really the issue? Apparently, it’s the fact there are some differences between jurisdictions in the timing and substance of trade execution rules. So some see the shift to trading overseas as a way for firms to avoid trading on SEFs, which they view as a bad thing, because:

“For US regulators, the new rules aim to bring swaps trading into the open and protect the US financial system from firms amassing huge derivatives positions in non-US markets.”

But that’s not the role of SEFs – that’s what clearing and trade reporting are all about. And as we noted, on these issues there’s not much if any difference between jurisdictions.

One final thought: the article begins with a chart that purports to show concentration in the derivatives markets. The data in question, however, is for the US only and includes only US banks. As we have written, the derivatives markets are truly global, and a look at our report here shows a more accurate picture.

Misperceptions like this… that’s why we’re hangin’ around, with nothing to do but frown….

See How They Run

Are financial regulators still flying blind when it comes to derivatives exposures?

It depends on who you ask.

On the one hand, there’s the Financial Stability Board’s paper – OTC Derivatives Market Reform: Sixth Progress Report on Implementation. It states (on page 29) that the Depository Trust & Clearing Corporation’s (DTCC) trade repository has captured 99% of all interest rate derivatives contracts outstanding and 100% of credit default swaps outstanding, when compared to the Bank for International Settlements’ semiannual survey.

That’s pretty good – and it shows the tremendous improvement in regulatory transparency since the global financial crisis.

To see for yourself, have a look at ISDA’s new website – ISDA SwapsInfo.org – which takes all of the public information reported by DTCC and transforms it into user-friendly charts and graphs. You can view activity and notional outstanding by currency, product type and maturity. This includes, by the way, market risk activity for the range of credit derivatives products.

IRD 300dpi

It’s worth noting that the information available to the public on this site and through the DTCC warehouse is only part of the data available to regulators.

So that’s the good news. There is, however, “the other hand” to consider. And it includes a collection of stories like this one from Bloomberg View. These articles claim transparency is still not where it should be and much more work remains to be done.

And you know what? In some cases, they are spot on. There is, for example, an increased threat of fragmentation in trade reporting because of competing trade repositories in different jurisdictions. As the Bloomberg article notes, this could impede the goal of greater regulatory transparency.

It’s also true that data alone is insufficient to give regulators the information and knowledge they need and require. In fact, in some cases, data alone might do more harm than good by providing a false sense of security without providing a true level of understanding.

So what’s the bottom line here?

Improvements – real improvements – have been made in ensuring data regarding activity levels and risk exposures are appropriately reported. We have come a long way since 2008.

But now, derivatives industry market participants and regulators need to work together on an important goal. It’s to ensure the information being requested is on point, addresses key public policy and risk management needs, and is timely.

Otherwise, we won’t be flying blind…but we will be running around in circles.

Crossing the Line

Question:
What do the EC Commissioner for Internal Market and Services, finance ministers in Brazil, France, Germany, Italy, Japan, Russia, South Africa, Switzerland and the UK, and regulators and central bankers in Australia, Hong Kong and Singapore have in common?

Answer:
They have all written to the US CFTC to express their concerns about cross-border derivatives regulations.

Why are they concerned?  As the finance ministers recently wrote:

“We are already starting to see evidence of fragmentation in this vitally important financial market, as a result of lack of regulatory coordination. We are concerned that, without clear direction from global policymakers and regulators, derivatives markets will recede into localised and less efficient structures, impairing the ability of business across the globe to manage risk. This will in turn dampen liquidity, investment and growth.”

To anyone who has watched this issue unfold over the past two or three years, such concerns are no surprise.  It is, though, a bit of surprise to see how The New York Times describes the situation.  Witness this page one headline from the Wednesday, May 1 paper: “Banks Resist Strict Controls of Foreign Bets”

There are (at least) three things wrong with these seven words:

1)      There’s nary a mention of the concerns of some of the world’s leading policymakers in the headline.

2)      No one is resisting strict controls.  The issue, as the finance ministers point out, is that “We share a common commitment with respect to OTC derivatives reform, and are implementing rules across very different markets with different characteristics and different risk profiles, to support this global initiative… An approach in which jurisdictions require that their own domestic regulatory rules be applied to their firms’ derivatives transactions taking place in broadly equivalent regulatory regimes abroad is not sustainable. Market places where firms from all our respective jurisdictions can come together and do business will not be able to function under such burdensome regulatory conditions.”

3)      Bets?  Even better, foreign bets?  How and why are derivatives transactions characterized as bets?  Is capping your interest rate exposure a bet?  Is hedging your currency exposure a bet?  Is protecting your credit exposure a bet?

We’re an international organization, and especially sensitive to these sorts of things, but even so, doesn’t this seem a touch xenophobic?  If the letter mentioned above had been co-signed by a US Treasury Secretary and sent to his EC counterpart, would it have been described in the same way?

But wait, there’s more.

Further down in the article, there’s this description of the “bitter international campaign” being waged by Wall Street and the world’s top finance ministers (as if they are working in concert):

“The effort…is just one front in the battle still being waged nearly three years after Congress passed the Dodd-Frank law, which revamped financial regulations in the United States in hopes of curtailing risky trading practices blamed for the global financial crisis in 2008.”

We’re the first to admit that the financial system needed strengthening (and we have made good progress doing so), but let’s not forget what the financial crisis was all about.  It was, first and foremost, about bad real estate decisions and bad mortgages. That was true in the US just as it was true in the UK, Ireland, Portugal, Spain and other hard-hit nations.

Unfortunately, The Times’ treatment of the important issue of cross-border derivatives regulation really crosses the line.

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.

It’s what you didn’t say….

A number of stories last week – like this one – chronicled the fact that regulations stemming from Dodd-Frank on the OTC derivatives markets have begun to take effect.

These stories quite frankly come as a bit of surprise.  But it’s not because of what they say.  It’s because of what they don’t say.

Let us explain.

Over the past two years we have seen and heard countless times statements along these lines:

“Representative Barney Frank, who was the co-author of the Dodd-Frank Act, says the law will help prevent a repeat of the financial crisis.”  (New York Times)

“The Dodd-Frank financial reform overhaul last year aimed to curb the excessive Wall Street risk-taking that nearly leveled the financial system.”  (Reuters)

These statements reflect that financial regulatory reform globally, and Dodd-Frank in the US, was intended to be fundamentally about reducing systemic risk: making the financial system safer and more robust, ensuring financial institutions took risk and capitalized against it appropriately and ending bailouts of too-big-to fail institutions.

In the OTC derivatives markets, this mostly meant increasing the use of central clearing, ensuring appropriate margins for uncleared swaps and improving regulatory transparency.

Significant progress has been made in all of these areas.  More than half of the interest rates swaps market is now cleared. Regulators have transparency into market-wide and individual firm risk exposures. The vast majority of OTC derivatives positions are collateralized.

This has all been done in advance of the imposition of the new rules. As a result, the system is much safer and stronger than two or three years ago. Further progress is on the way, and it will be safer and stronger still.

Most of this remains unsaid. Much of the focus last week was instead on non-systemic issues that are not central to the fundamental goals of regulatory reform.