Timothy Geithner has been setting the American regulatory agenda for systemic market risk for some months now. In mid-May the 47-year-old secretary of the Treasury put forward a conceptual blueprint for regulating over-the-counter trading in the vast global derivatives market, focusing not just on troublesome credit default swaps but also on all derivatives that can be easily standardized, centrally cleared and even moved onto exchanges.
He reiterated his position in mid-June, a few days ahead of the regulatory program announced by President Barack Obama. The push comes as no surprise to market participants accustomed to trading in the unregulated $592 trillion global derivatives market. They’ve all known that regulation was coming — but Geithner’s plan goes further than expected. It provides better visibility into systemic financial risk, injects more efficiency and transparency into the markets, clamps down on price manipulation and adds new rules ensuring that derivatives aren’t peddled to unsophisticated investors.
The proposal for derivatives regulation embraces and distills some ideas that have been circulating for a while on Capitol Hill. Most telling is the call for mandatory centralized clearing of credit default swaps. These derivatives contracts, which are used to protect against corporate defaults, contributed significantly to insurer American International Group’s record loss of $61.7 billion in the fourth quarter of 2008 (CDSs constituted $41.9 trillion of the global OTC derivatives market in December 2008, according to the Bank for International Settlements). But the proposal goes beyond focusing on a single product or market by suggesting that securities laws be amended to require most OTC derivatives to be cleared through internationally recognized and regulated central clearing counterparties.
Derivatives markets that lend themselves readily to standardization, such as that for equity-index-linked credit default swaps, would also have to be moved onto regulated exchanges, to ensure market efficiency and price transparency. To avoid attempts to skirt the regulators by simply creating customized derivatives contracts, so-called look-alike contracts would be prohibited. But market participants are still wondering how, exactly, existing OTC derivatives are going to be divvied up. “The challenge is really where that line is going to be drawn between the customized world and the standardized world,” says Robert Pickel, executive director and CEO of the International Swaps and Derivatives Association. “That distinction has yet to be made.”
Some quantitative hedge fund industry veterans who trade thousands of options and derivatives contracts daily are only too happy to see any distinction being made — not least because broker-dealers have long had the freedom to name their price in OTC markets and any regulatory mandate that pushes standardized contracts and trading onto electronic exchanges will increase price discovery and transparency. But no one expects the banks to comply enthusiastically. “The banks are making easy money,” says a longtime European hedge fund manager. “So they will fight fiercely any regulatory attempt to move CDS contracts onto exchanges, because if you can trade plain-vanilla CDSs on an exchange, you ought to be able to trade almost anything on an exchange, and the banks don’t want that.”
Geithner’s approach would likely demystify a major source of systemic risk in the global markets and force much of the worldwide trade in OTC derivatives into regulatory daylight.
