The Changing Systemic Risk Regulatory Landscape
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Agriculture is not the first word that comes to mind when contemplating systemic risk regulation, but the Senate Agriculture, Nutrition, and Forestry Committee was the gladiatorial arena for systemic risk regulation of derivatives last week. Agricultural commodities are traded on the Chicago Mercantile Exchange and the Commodities, Futures, and Trade Commission (CFTC) regulates commodities trading, and the Senate Agriculture Committee oversees CFTC. A week ago, the Senate completed nomination hearings for Gary Gensler, the new CFTC Chairman. Gary's nomination was approved unanimously by the committee, and his participation in the hearings last week on "Regulatory Reform and the Derivatives Market" was his 8th day on the job. But judging by his testimony performance, it is easy to see why both Democrats and Republicans love him. He's smooth, diplomatic, and combines left and right positions in the same sentence. Other expert testimony came from:
Ms. Lynn Stout
UCLA School of Law
Los Angeles, CA
Mr. Mark Lenczowski
J.P. Morgan Chase & Co.
Dr. Richard Bookstaber
New York, NY
Mr. David Dines
Cargill Risk Management
Mr. Michael Masters
Masters Capital Management, LLC
St. Croix, USVI
Mr. Daniel A. Driscoll
Executive Vice President and Chief Operating Officer
National Futures Association
Lynn Stout and Michael Masters presented populist, anti-establishment, arguments for regulatory reform. Mr. Masters has impressed me in the past with his presentations on derivative markets, and in his testimony he pushed hard for notional derivative clearing and exchange trading. Mark Lenczowski and David Dines toted the bank party line on the need for choice in derivative markets, the complexity of the OTC market, and the extra costs standardization of derivatives would add to transactions. Rick Bookstaber made some reasoned and logical remarks about how easy it would be to standardize derivative trading and why it would be desireable to put it into an exchange. He said that the opacity of derivatives makes them the weapon of choice for gaming the regulatory system, that banks use them to acheive investment goals that hide leverage, skirt taxes, and obfuscate investor advantage.
The key battle positions now are:
Conservative: Leave things as they are with greater capital and margin requirements, some transactional reporting. The banks contend that exchange trading is an option in today's market but that customers should decide whether they want to buy derivatives on exchanges or via OTC. Banks already face Capital and margin requirements on derivative trading, so new limits would largely impact non-bank derivative market players. An enhanced status quo seems unlikely, and I think the banks know this and thus are taking this position as a negotiating tactic to limit the Moderate choice.
Moderate: Force derivative trading into clearing houses, require capital and margin requirements, set new position limits on holdings, and use TRACE to track market transactions. This is the essence of the Geitner proposal and Mr. Gensler espoused this position eloquently. I also believe that the banks are comfortable with this solution, because they created the clearing houses and have enormous influence there. The new capital and margin requirements would make benefit the 14 primary broker dealers and if the banks are going to give up some opacity through clearing houses they want at least to ensure a cartel status for derivative dealing. Because Gensler and Geitner are already on board with this, and bank lobbyists are behind their support, I see the moderate option the most likely.
Liberal: Force derivative trading into an open exchange in which all transactional volume, price discovery, bid/ask, etc is fully transparent. This option creates the greatest market efficiencies and allows any dealer of any size to participate in a very liquid and open derivative market. In the beginning, there would be some semantic challenges packaging bespoke derivatives into mass-customized and standardized products. But the data models and technology exists to perform these data gymnastics and the industry would, over time, become adept at provide customized derivative products in standard offerings. In an exchange, it is harder for banks to game the system, and the benefits of derivative trading are more widely shared. Thus, banks want to avoid this. Unless Obama comes out in favor of exchanges, I see the Liberal option falling to the bank cartel.
The challenge with any of these scenarios is enforcing positional limits. CFTC, and the Senators, want the regulatory power to impose position limits. This would entail positional reporting and some kind of kick-back function at the clearing house or exchange to limit registered broker/dealer transactions. But the technical solution has some complexities not obvious to the untrained senatorial eye...
A derivative position is not the same as an equity position. When I own two shares of IBM Stock, they are two units of the same instance. When I own two XYZ currency swaps with the same maturity date, they are two instances of the same unit, and they may also have other characteristics that make them different. It is not possible to add up all the derivative units at the end of the day and compare them in the same way as you might with equities. You have to record each transaction and tally up the common elements, and then you need to analyze all the composite positions to determine what they mean.
One imortant thing that all the panelists missed is the fact that it is not possible to standardize derivative products, per se. It is the components and their semantic definitions that can and must be standardized. That is, a Chevy and a Ford are both cars but they are different types of cars. Yet both have standardized components (often made by the same parts suppliers) that make them subject to classification and their functions interchaneable. We need the same kind of classification of derivative components, so that every buyer and seller can set the features they want for the financial goals they have.
By standardizing derivative components, and plugging them into a configuration engine, it will be possible for an exchange to offer customizeable derivative products to any buyer and seller in the same way as banks do today via the OTC market. The conditions may vary, but the components will be interchangeable. This is the dirty little secret banks don't want anyone to know. Because when exchanges can offer mass-customized derivative products, the huge transactional fees that banks derive from the opacity of risk will evaporate...
A few months ago, the big talk in DC, NY, and among academic circles was that the CFTC would get merged into the SEC, and that the Fed would assume responsibility as the systemic risk regulator. I think that talk is now dead.
Last week, Mr. Harkin, Chairman of the Committee, and Mr. Chambliss, the ranking republican, made many mentions and requests of Mr. Gensler on his resource requirements for regulating derivatives in CFTC. Mr. Gensler mentioned that the CFTC is woefully underfunded, with only 570 people on staff, and the commission would have to double in size at least to manage the complex derivative market. Harkin and Chambliss made it quite clear that Mr. Gensler would be getting new authorities and new funding, signaling to Treasury that CFTC will remain independent and overseen by Harkin and Chambliss in Senate Agriculture, thank you very much.
Power being what it is, the deck chairs in Washington will not be changed. Systemic Risk will be regulated in parts and pieces. I predict we have Systemic Risk Governance Councils in our future and that all the major regulators will get new authorities, new funding, and oversight from the same crusty old men and women in Congress who failed to oversee and fund them correctly prior to the crisis...