A Piece on Financial Derivatives Regulation in FT Alphaville
| Craig Pirrong |
FT Alphaville, one of the Financial Times’ blogs, kindly asked me to contribute a guest post on the financial-markets regulation legislation currently working it’s way through Congress. (Thanks, Stacy-Marie.) Here’s what I wrote:
Lawmakers in DC are due to resume debate on major financial-reform legislation currently working its way through the US House of Representatives. One closely watched aspect of that debate is sweeping overhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.
In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets. These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them.
Standardized exchange products with central clearing are well-suited for some products and some users, but more customized arrangements (including customized, bilateral agreements relating to counterparty risk) are preferable for others. And one should be extremely skeptical about claims that to enhance their profits, greedy bank-dealers force derivatives end users into trading on opaque, concentrated markets instead of transparent exchanges; end users have had the opportunity to choose, and exchanges have competed aggressively to try to attract them, but many end users nonetheless have decided to trade in markets that are allegedly stacked against them. Is it really wise to predicate a radical restructuring of markets on the view that end users are suffering from the financial analog to battered spouse syndrome?
Ironically, one of the controversies that has come up in the debate over amendments to the proposed legislation involves supposed backsliding from the old time standardization religion. An amendment changes language defining “swaps execution facility” to allow trading of swaps through voice brokers to meet the bill’s requirement that swaps be traded on such a facility or an exchange. Moreover, other language in the amendment allegedly allows banks to continue business as usual. That is, whereas reform advocates envisioned that under the new law swaps would be traded almost exclusively on exchanges or transparent, exchange-like venues, they claim that the new language would perpetuate the existing ways of trading swaps in scary “dark” markets.
This is not a bad thing at all — contrary to what some have argued. A variety of execution mechanisms developed to satisfy the disparate needs of market users with respect to pre-trade and post-trade transparency, credit and collateral arrangements, and product design. To the extent that the amendments recognize this reality, and give market participants some flexibility in selecting the mechanisms best for them, the authors are to be commended. To the extent that the bill still imposes unnecessary mandates, they are to be criticized.
One final note: proposals to force derivatives trading onto exchanges have been tried before — back when grandma wore high button shoes. As financial markets developed, these restrictions proved unworkable and unwise. The advocates of one-size-fits-all reform would have us repeat the same errors. Back to the future is not progress.
[The background here is that the first regulation of futures trading in the US, the Grain Futures Act passed in 1922 required all “contracts for future delivery” to be traded on “a designated contract market” (i.e., an exchange). The Commodity Exchange Act (passed in 1936) extended this to non-agricultural commodities. This created huge issues starting in the 1980s particularly when new products that had futures-like features started to be traded OTC, and banks starting offering products to retail customers that had interest rates tied to the S&P or gold. The question became: what was a future? One-size-fits-all became clearly unworkable.]