Dealing with the "Unknown Unknowns" of Derivatives Markets

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by Viral Acharya and Marti Subrahmanyam

A key aspect of the bill on Restoring American Financial Stability proposed by the Senate Banking Committee under Senator Christopher Dodd is the sweeping reform of the derivatives markets targeted at improving their transparency and accountability. The bill aims to "eliminate loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter (OTC) derivatives." 
In particular, the Bill (i) provides the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) with authority to regulate the OTC derivatives; (ii) requires central clearing and exchange trading for derivatives that can be cleared and provides a role for regulators and clearing houses to determine which contracts should be cleared; (iii) requires margin for un-cleared trades in order to offset the greater risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets; (iv) requires all swap dealers and major swap participants to be subject to capital requirements; and, (v) requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring risks.

There is much to applaud in these proposals. They tackle several problems with the OTC derivatives markets, with credit default swaps (CDS) in particular, that came to light with the failures of Bear Stearns, A.I.G. and Lehman Brothers.  The key issue was that of opacity, or the problem of "unknown unknowns": The first "unknown" being whether there is counterparty risk from failure of a large financial firm that could cause trouble at firms that are connected to it through OTC derivatives; and the second "unknown" being how large is the extent of this counterparty risk.  The scale of this issue compromised regulators into backstopping bad assets of Bear and counterparties of A.I.G., and it brought the world to  its knees following Lehman's failure.

Does the Bill fully deal with this difficulty of "unknown unknowns" of OTC derivatives?  The answer is somewhat mixed. On the one hand, it is clear that single-name CDS on corporations and sovereigns will likely move to central clearing platforms (and possibly over time to exchanges).  This would significantly reduce the opacity in these products.  However, since the Bill requires transparency primarily for the cleared derivatives, the status of un-cleared derivatives remains open. Instead of requiring mandatory disclosures of these remaining OTC positions, the Bill puts the burden on regulators to impose margins or capital requirements, hoping that they would be large enough to contain risks and wherever possible get trading to move to centrally cleared products.

Can such margins or capital requirements be designed effectively?  At one extreme, suppose the un-cleared OTC positions were required to be fully collateralized. Then, counterparties will most likely find it cheaper to take on "basis risk" by trading in standardized products that are cleared rather than the customized ones they desire.  Another, somewhat more subtle, device would be to legislate that in event of default, OTC counterparties are junior to any centrally cleared or exchange-traded claim.  This would ensure that un-cleared OTC products still exist but are subject to substantial counterparty risk or high margins; in turn, these products would be worthwhile only if customization gains are sufficiently large.

So if the goal is to shrink the size of opaque OTC markets, regulators can simply raise their margin requirements to prohibitive levels.  However, in many cases, OTC products are unlikely to have any centrally cleared counterparts.  How should the regulators deal with such products?  Elsewhere in bank regulation, capital requirements designed by regulators have fallen woefully short of containing systemic risk and leverage.  There is no reason to believe the outcome here would be any different.

A better solution would be to require transparency of dealers' and large swap players' exposures for all OTC products, and not just centrally cleared ones, at regular intervals.  The information overhead can be minimized by classifying products into types such as single-name or index CDS, interest rate swaps, currency swaps, among others and requiring disclosure by category and maturity.  Each dealer should be required to report its gross and net exposure to each other counterparty including the extent of collateralization. Such disclosure is not that onerous. Investment banks maintain such information for their internal risk management purposes, publish some of it in their quarterly reports, and it would not be a huge burden to disclose it to regulators in a standardized format at frequent intervals, say weekly. Some aggregated versions that respect customer confidentiality can then be transparent to markets at large.

Such transparency of counterparty exposures will create a tiering of financial firms in each OTC market, effectively directing new trades towards the least risky counterparty.  Even if regulators were to design margin requirements themselves, the proposed OTC transparency would help.  For instance, if regulators required that the largest counterparty exposure of each financial firm be sufficiently well collateralized, then we would have effectively hedged away a significant part of the counterparty risk in OTC markets at a reasonable cost.  And in case of failures, regulators would know exposures with precision.

To summarize, while the Senate Bill in the United States is a giant step forward to improving the regulation of OTC derivatives, several baby steps in implementation remain to be taken.  Effective functioning of the OTC markets should rely more on transparency and less on rules designed by regulators.  A pragmatic approach would be to first move single-name and index CDS to central clearing and adopt margin requirements for those CDS that remain OTC.  CDS trades inherently feature "wrong way" exposures since credit risk is tied to the macroeconomic cycle, so that it materializes precisely when counterparty also becomes riskier.  Hence, CDS regulation must move first.

To minimize regulatory overload, other derivative markets should be added only if they merit similar scrutiny.  While CDS reforms are being put in place, regulators should require disclosure to understand the quality of bilateral margining and risk management in interest rate, currency and commodities derivatives.  Based on such information, we would be able to assess whether additional regulation is needed in these markets.  This way, we would have removed over time the "unknown unknowns" of OTC derivatives, for market participants as well as the regulators.  

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

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Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

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