Regulators as source of financial instability: reform adds more twists to convoluted derivatives world

An article by Jesse Eisinger in the NY Times Dealbook looks at derivative regulation and how it is a source of financial instability.

The challenge regulators face with derivatives is to reduce the risk of an "opaque system prone to failures".

Regular readers know that when I hear about a part of the financial system that is opaque, my first reaction is to ask what would be the best way to implement transparency.  The answer to this question is driven by understanding what are the problems that need to be fixed.

In the case of derivatives, the problems that need to be fixed are:

• contagion - where the failure of one large player could cause the entire financial system to collapse; and 
• capital - ensuring that each counter-party in the derivatives market has enough equity to cover their losses.

Fortunately, both of these problems are easily fixed by requiring each financial institution in the derivatives market to disclose their current position-level detail. With this data, market participants can assess the risk of each institution.

Naturally, market participants will not purchase derivatives from financial institutions/counter-parties that do not have enough capital.  By adjusting their exposures based on the counter-parties ability to cover any losses, market participants solve both the contagion and counter-party problems.

Unfortunately, regulators have chosen not to adopt current position-level disclosure.  Instead, working with Wall Street's Opacity Protection Team, they have elected to build 'a huge Rube Goldberg-like system'.

When the architects of the Dodd-Frank regulatory overhaul flinched from the most effective solution ... they forced regulators of the derivatives market into a cumbersome and potentially dangerous workaround. 

Those regulators are feverishly making lots of important, arcane rulings that are being followed only by insiders. 

They are replacing an opaque system prone to failures with a new, huge Rube Goldberg-like system that may reduce global financial risk. Or it may not. Nobody knows, not least the regulators themselves.... 

A clearinghouse is a central body through which trades take place. It is supported by its financial firm members. For instance, if JPMorgan Chase enters into a derivatives transaction with Goldman Sachs, their deal would go through a clearinghouse, which is liable for the trade if one of those banks fails. 

The big banks that dominate derivatives trading resisted letting in smaller firms, arguing that doing so would make the clearinghouses vulnerable. They have a point: a clearinghouse with a bunch of undercapitalized members would be more prone to failure, unable to pony up when one side of a trade defaults, and we would be back where we started.... 

But excluding the small fry is dangerous as well. If clearinghouses restricted their membership to only the biggest and best-capitalized firms, the markets would more or less look like they do today — an oligopoly. 

Derivatives trading is dominated by the likes of JPMorgan, Goldman Sachs and Deutsche Bank. We now have a financial system where the failure of one megabank can jeopardize the world financial system, and having clearinghouses run only by the “too big to fail” firms merely replicates that fundamental problem.... 

Another insoluble problem is that of the One or the Many. If there were only one giant global clearinghouse for all derivatives, it might have enough capital to survive a panic in any one corner of the derivatives market. But if a general financial crisis forced many members to default, then it really would be too big to save. No country, not even the United States, would allow such a gargantuan institution to be domiciled on its home turf. 

Instead we have an explosion of clearinghouses. We have clearinghouses for different asset classes. We have competing clearinghouses....

That leads to another concern. Clearinghouses create an impression there’s some underlying capital to protect them, either in the entity itself or among the members. But a multiplicity of small ones is dangerous, according to Frank Partnoy, a professor of law and finance at the University of San Diego. The fragmentation means that safety is likely to be an illusion. 

“There is less money” in each tiny clearinghouse, he explained. It virtually guarantees that if there’s a panic in one area of the world, the clearinghouse that backs it won’t have enough capital. 

The regulatory changes could make things worse in another way, said David Murphy, principal of the risk management firm Rivast Consulting and a former head of risk at the trade group International Swaps and Derivatives Association. Here, it’s worth knowing a little about how banks minimize risks as they trade derivatives. 

The underlying amount of derivatives, called the “notional value,” is in the hundreds of trillions. The biggest dealers, like JPMorgan, have tens of trillions of notional value on their books. What we are worried about is counterparty risk: what happens if one of the banks on either side of a trade fails?... 

“The scary part,” said Mr. Murphy, the risk expert, “is that I’m pretty certain that clearing is being imposed without anyone actually knowing whether it actually reduces counterparty risk or not." 

One sure thing in this morass of uncertainty: We will find out.