Do the supervisory groups pushing for market reform really understand the ins and outs of the CDS market?
Policy makers on both sides of the pond threatened more regulation for the credit derivatives market including mandated central clearing of CDSs and a ban naked CDS positions. Market participants are understandably concerned about the newly proposed policies and talk of extending regulatory oversight, and some market leaders explained this week the dire consequences these changes in governance would have on the future of the credit derivatives market and the health of the financial industry.
So, who knows best when it comes to market reform? The debates of the past week seem to point to a larger issue – there is still a massive gap in understanding how the CDS market operates and contributes to the larger financial industry.
But first, a review on what happened this week?
In the U.S, the House of Reps Committee of Agriculture reviewed the “Derivatives Markets Transparency and Accountability Act of 2009,” a draft bill which aims to extend the CFTC’s oversight of the over-the-counter derivatives industry, including CDSs and interest rate swaps. Specifically, this bill, which was drafted by Committee Chairman and D-Minn, Collin Peterson, would ban naked CDS positions and introduce new reporting requirements to be regulated by the CFTC.
According to the Committee, this bill “is designed to bring greater transparency to futures markets and to bring a sense of order to the over-the counter market for swaps and other credit derivatives,” but at what cost to the market now and in the long run?
In his testimony at a hearing on the Peterson Bill this week, ISDA executive director and ceo, Robert Pickel explained the dire consequences this legislation, if implemented, will have on the CDS markets and future health of the financial industry.
Pickel made several points explaining how specific areas of the bill would inflict severe harm on the functioning of the CDS market and its participants by impairing their ability to hedge risks, limiting access to the futures market which would probably result in only more costly hedging strategies, reduce liquidity and increase volatility. He noted such ill effects would also harm mainstream American corporations – a point that legislators would surely take note of. In addition, Pickel reminded policy makers that the derivatives industry contributes to the strength and vitality of US financial system, and as consequence, play a large role in regaining the health in the financial industry and economy.
The main debate revolves around the bill’s ban of naked CDS positions in attempt to limit speculation on CDSs, a move which Pickel said would ISDA essentially ‘eliminate the CDS business in the United States.’
The Peterson Bill also calls for central clearing of CDSs via a regulated organization – a portion of the bill that Pickel deemed ‘unwarranted’ in the ISDA press release.
EU Internal market Commissioner, Charles McCreevy also urged the mandating of a central clearing facility for CDSs in an address he made earlier this week to the Committee on Economic and Monetary Affairs.
In a public release McCreevy described the industry’s response on the issue of clearing ‘disappointing,” and he added, “I had hoped the industry would agree on the necessity to clear trades on EU entities on at least one CCP in the EU. However at the last minute they pulled out of an agreement and now a regulators approach is necessary.”
Unless you’ve been asleep for the past six months, you will know the background to this statement is that there has been progress in this arena which several exchanges prepping plans to launch such a service in early ’09, including Liffe and Eurex and in Europe. It is also important to note, as pointed out in ISDA its public response, McCreevy rejected the industry commitments made on the topic of central clearing as proposed to multiple regulators in both July and December of last year.
In a formal response to McCreevy’s statement on clearing, ISDA chairman and head of European credit at Credit Suisse, Eraj Shirvani said;
“The industry has been the first mover on this matter, pursuing industry agreement on central clearing for CDS as early as 2006 and making global regulatory commitments in mid-2008, while also delivering industry-wide clearing solutions for a range of OTC products. We continue to urge coordinated global dialogue with all concerned regulators as a matter of priority. We respectfully urge the European Commission to resume its dialogue with the industry.”
I think a better question would be why did market players pull out of the requirement for a CCP? Could they have second thoughts of the consequences of central clearing and require time to consider all options?
Also, this week the WSJ reported that regulators were pondering an extension of the Fed’s oversight responsibilities to include unregulated products including derivatives – a move that would undoubtedly have ill-effect on hedge funds and private equity firms.
John Jay, senior analyst at Aite Group says such a move would put the ‘kibosh’ on risk taking in these markets.
In a public statement, Jay said:
“If the Federal Reserve does eventually oversee derivatives, hedge funds and private equity firms, it does seem like a natural progression in consolidating all the disparate functions that are now spread across multiple agencies. With the many banks now also required to report into the Fed, it is also a logical central repository for flows of fund data. However, the risk is micro-managing the process of placing the capital-at-risk. The risk-reward calculus may shift to suboptimal conclusions (e.g., violation of restrictive rule, ROI outcomes too low) which may lead to the decimation of those firms that are being overseen. For the government, it will be a balancing act between providing necessary transparency and the destruction of economic rewards inherent in these businesses.”
More specifically, the concern is that the Fed will go overboard in oversight and too involved which could, for example, create an implicit approval process for financing and projects such as getting loan or entering into a new business venture or partnership.
The consequences of putting down legislation as a ‘knee jerk response’ to the current market upheaval may not be evident in a couple months, but will become apparent on a year or two when suddenly the market has changed so significantly that, for example, risk taking isn’t even part of the equation, noted Jay.
According to Jay, a move to improve accountability and coordination among the regulatory agencies makes much more sense.
I cannot speak about improvements made in coordination among the regulatory bodies but the Operations Management Group (OMG), which is made up of trade associations and the top sell-side and buy-side firms, has attempted to improve the communication with all three regulatory agencies – CFTC, SEC and the Fed in the last year or so. The OMG outlined clear goals in both the July and October letters. Sure, not all goal deadlines have been met (in fact many haven’t) but the U.S. regulators publicly recognized the industry’s efforts to address problems and create a more robust market. In doing so, it seemed that the regulators were willing to allow the market to attempt to fix itself (as it did with confirmation backlogs a few years back). And why wouldn’t they? Surely market participants are more experts in this then the regulators?
So who knows best anyway?
It seems some groups don’t really understand the CDS market. Evidence of this is all over the place and in many forms – look at the many blogs out there that debate the REAL use of a CDS for starters.
And more events this week point out this gap in market understanding. Madoff case whistleblower, Harry Markopolos called the SEC ‘financially illiterate’ speaking to the House Financial Services Sub Committee on Capital Markets, Insurance and Government Sponsored Enterprises earlier this week. Markopolos suggested the group hire employees who understand the markets and have Wall Street experience.
This lack of financial literacy is much more wide-spread. Policy makers are eager to put a band aid policy on the current market problems by imposing new regulation and legislation, but this quick fix fails to effectively investigate the true source of the market upheaval or provide ‘fixes’ that would serve the market and economy in the long-term.
Besides, if you want to have regulators oversee credit derivatives then shouldn’t the agencies first improve their ability to understand these unregulated products, namely how they are really used and how they affect all market participants (buyside and sellside) and the financial system at large?
Markopolos also noted in his speech that the unfriendly relations (and that is saying it delicately) between the Boston and NY SEC regional offices was a major obstacle in uncovering the Madoff fraud earlier. This points to John Jay’s comment that ‘coordination’ among regulators is essential first step. Given we have multiple regulatory bodies at play here in the U.S., shouldn’t regulators learn how to play nice first?
Another problem, again highlighted by Markopolos’ testimony is that regulators seem to be too friendly with Wall Street. In his speech, Markopolos implied that regulators enjoy, to some extent, cozy relationships with the big dogs on Wall Street, which was why he was so cautious and fearful in reporting the findings of his investigation to the authorities.
So, what do market participants suggest be done? Training for regulators and policy makers? Hiring more Wall Street experts at the regulators, banning friendly lunch dates among banks and regulators? Or perhaps the ‘transparency’ Peterson aimed for in his bill should be applied to more than just the CDS market? Any suggestions?