Some Takes on the Regulatory Overhaul
Here are some assessments of the Obama administration’s overhaul of financial regulation:
In his front-page New York Times article on Wednesday (upgraded from the left-hand column of the business section), Joe Nocera finds “only a hint of Roosevelt” in what Obama described as “a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.”
Michael Greenberger of the University of Maryland comments on the new regulations in an interview on WBAL Radio, AM 1090 (Baltimore) on Wednesday (it opens up directly into Quicktime audio, but the interview comes through just fine).
And Greenberger contributed to this piece from Reuters (also from Wednesday).
There’s a new sheriff in town, and the freewheeling era of the credit-default swap is about to fade into the sunset. As part of the overhaul of financial regulation to be announced by the administration today, Treasury Secretary Timothy Geithner has signaled that he plans to corral these troublesome trades. When it comes to instruments like credit-default swaps and that whole class of derivatives blamed for battering the economy, everyone is speaking the language of change. Unfortunately, everyone also has a different idea of what that means. Populist outrage is running high, both branches of Congress have bills percolating that would impose strict governance on trading, and the Commodity Futures Trading Commission wants to solidify its relevance in a climate of political uncertainty. There are a lot of different opinions—and divergent agendas—on how to manage these fiscal problem children.
Part of the problem is that even administration officials are divided on how to handle derivatives. The two main camps are exchange trading and clearinghouse oversight. In a May 13 letter, Geithner called for unregulated derivatives trading to occur via one or more central clearinghouses. He stopped short of mandating that all such business must be conducted on an exchange, allowing that some customized derivatives contracts could still happen over the counter (that is, privately). Senate agriculture committee Chairman Tom Harkin, D-Iowa, went further and called for a mandate to have all derivatives treated as futures contracts and traded on an exchange. Gary Gensler, President Obama’s nominee to head the CFTC, has sought to split the difference, telling the agricultural committee in a speech on June 4 that derivatives should be regulated by his commission as strictly as exchange-traded instruments, although he didn’t say they have to be traded on an exchange.
Before we go too much further, it’s important to keep in mind that both Harkin and Gensler have vested interests in how this turns out. A cynic might consider Gensler’s eagerness to craft a broad new role for the CFTC disingenuous given the widespread speculation earlier this year that the administration might close the agency and fold its duties into a beefed-up SEC. For his part, Harkin might also be guilty of self-interest. The agricultural committee is the CFTC’s bureaucratic “parent.” While their motivations may be upright and more oversight would be great, it can’t hurt that such changes would solidify the relevance of each man’s respective Beltway fiefdom.
So let’s take a look at the question of clearinghouse vs. exchange. While both cover some similar turf, there are also big differences that would affect their performance and, possibly, their ability to weed out abuses. Firstly, the two entities aren’t mutually exclusive. Exchanges generally include clearinghouses, but a clearinghouse can also exist as a standalone entity. A clearinghouse functions as a kind of fiscal referee. It makes sure participants aren’t too deeply indebted and make good on their contracts and records price information. An exchange would do much the same.
Exchanges offer one clear advantage in terms of transparency, though. A clearinghouse gathers and publicizes pricing data only after transactions take place. But an exchange would create what the experts term “price discovery.” It would do for the derivatives market what e-commerce did for the retail landscape. If you wanted to buy a set of patio furniture in the pre-Google (GOOG) years, you would just go to the store and pay whatever the tag read. Now, with a few keywords and clicks, you can comparison shop among dozens of merchants.
Banks abhor regulation in general and exchange-trading requirements in particular. If given any say at all (and their lobbyists are insuring they probably will be), they’d prefer a clearinghouse option with healthy exceptions—some would say loopholes—for custom-built credit instruments. What banks really want to avoid is mandatory exchange trading because they pocket the difference between the asking price and the offered price in an opaque market. This difference would still be present in exchange-traded products, but it would be much smaller because everyone would be able to see the going rate, so bid amounts would be much closer to sellers’ asking prices.
The price transparency afforded by exchange trading has another advantage not directly related to the trades themselves. With prices out in the open, everyone from private-sector analysts to academics to policymakers will be able to see fluctuations as they happen and possibly catch the next bubble before it mushrooms out of control. In short, having more pairs of eyes is a good thing. Like getting a friend to proofread your résumé on a macro scale.
If exchange trading is required, banks would also lose the opportunity to make money off customized offerings, a relatively small niche that pulls in larger returns—a revenue source they’re loathe to relinquish. All exchange trading takes place using standardized contracts, which takes pricey customization out of the equation. Banks argue that the degree of customization necessary for more complex derivatives is too great for them to shoehorn these contracts into a standard format. But critics are quick to point out that banks can and do charge a lot more for creating a custom contract, making their protest a bit suspect, especially since some relatively complex “standard” instruments already exist.
Banks also argue that forcing every trade onto an exchange will stifle innovation. That’s certainly possible. And it also might not be a bad thing. When JPMorgan (JPM) invented credit-default swaps back in the ’90s, it could package and sell them directly to clients—clients who probably didn’t really understand just what this new toy they were purchasing could do. In 2000, when the Commodity Futures Modernization Act explicitly excluded CDS from regulation, the move was widely viewed as one of resignation. The market for swaps and related derivatives had grown into a thicket of economic kudzu so quickly that regulators decided to leave it be rather than hack through it. Given what CDS have given the world in recent years, it could be argued that a little vetting on the front end might have given market participants a better understanding of the inherent risks before they got in over their heads.
Some people worry that the clearinghouse option—which the banks view as the lesser of two evils—doesn’t carry enough regulatory clout to prevent risky trading. As this New York Times article points out in great detail, a clearinghouse could wind up being owned by the banks it’s meant to regulate. Fox, henhouse, and so forth. ICE U.S. Trust, widely seen as the front-runner clearinghouse, is 50 percent owned by some of the biggest banks in the business. Critics worry that if the home team is also the umpire, it’ll permit generous exceptions to disclosure requirements.
restingly, this isn’t the first time the United States has considered a centralized oversight vehicle for these kinds of instruments. Back in 1984, long before subprime mortgages and credit-default swaps hit the scene, Fannie Mae proposed a “national mortgage exchange” to regulate the complex universe of mortgage-backed securities that could, in the words of one official, “slid[e] into chaos.” The agency pledged $10 million to start up the exchange but scuttled the idea a few years later after deciding that the private sector had stepped up its efforts to keep mortgage-related trading running smoothly. The powers that be should keep this in mind as they weigh who to trust with this complex arena.
Explainer thanks Michael Greenberger of the University of Maryland, Gary Kopff of Everest Management Inc. (formerly of Fannie Mae), Kevin McPartland of the Tabb Group, and Ann Rutledge of R&R Consulting.
Hat-tip to Lynn Fries for these links (though I’d seen the Nocera piece in my morning paper).