Unlike transparency, debate rages over benefit of derivative reforms

The International Financing Review ran a terrific article on the question of does the benefit of the proposed reforms of the derivative market exceed their costs.

Unlike transparency, where the benefit is measured in trillions of dollars and the cost measured in single billions of dollars, the case for the proposed reforms of the derivative markets is not so clear cut.

This is not surprising.

The complex rules and regulatory oversight being brought to the derivatives market is a belt and suspender imperfect substitute for transparency and market discipline.

As an imperfect substitute, complex rules and regulatory oversight is much, much longer on costs with far more ambiguous benefits.

This is a very important point as Wall Street has turned to the court system to have complex rules and regulatory oversight thrown out when it cannot be shown that its benefits outweigh its costs.

The Macroeconomic Assessment Group on Derivatives – a body of prudential and securities regulators chaired by the Bank for International Settlements – calculated OTC derivatives reforms would boost annual GDP growth by as much as 0.13% by avoiding future derivatives-fuelled crises. 

Some derivatives experts have questioned the findings, though, which could even be cynically interpreted as an exercise in self-validation... 

Craig Pirrong, professor of finance at the University of Houston, argues the group’s analysis is fundamentally flawed, as it evaluates derivatives regulations in isolation of the rest of the financial system and fails to account for spillover effects to other market participants.... 

The MAGD report reckons the regulations stemming from the G20 mandate of increased capital requirements, central clearing and initial margin for uncleared trades should be enough to prevent derivatives exposures from sparking future crises “absent the remote possibility of a CCP failure”. 

Using CDS default data, the group calculates the annual probability of derivatives fuelling a financial crisis at 0.26%. The Basel Committee has previously estimated the median cost of financial crises is 60% of annual GDP, meaning the implementation of the reforms should boost annual GDP by 0.16%. 

Meanwhile, the costs to the economy of higher collateralisation and forcing banks to hold more capital will reduce annual GDP by 0.03% to 0.07% depending on the amount of netting that can be achieved through central clearing, the group calculates. 

But Pirrong argues this is an overly-simplified analysis of the impact of derivatives market regulations, which only examines part of the picture. Overall, the concern is derivatives reforms merely redistribute losses elsewhere in the financial system in a way that may still undermine market stability. 

“The reforms do dramatically reduce systemic risk in derivatives markets. But they also have the effect of promoting derivatives counterparties to the head of the bankruptcy queue, which inevitably means somebody else will get less money,” said Pirrong.