Thursday, December 17, 2009

The Devil Is in the Details

Mike Konczal at Rortybomb disagrees with Economics of Contempt's recent post in these pages about the proper regulatory structure for derivatives trading:
To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!

I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.

Even better, Mike is not content just to hurl brickbats and criticism. He explains in an accompanying post exactly what it is he is looking for in derivatives trading reform:

Let’s define some terms. Many people are comfortable forcing OTC derivatives to be forced into clearing (though I don’t think the author above does). I like that, but I and others worried about financial reform want to see more. Let’s talk about exchanges versus clearing. Now as opposed to the FT article, I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world. What I am worried about is that the swap execution facility will move away from a formal “trading facility” definition towards a vague nebulous definition of whatever people can get away with.

So what are the features that I want to see? I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.

Right now people will tell you that clearing derivatives still gives market prices, and these prices can be transparent with a few tweaks. However a clearinghouse only sees one price, the price at which the deal was struck, and it only sees that price after the deal is completed. So yes, this is a history, but it is only a partial history. A fuller price history will give us information available for use by many different parties to carry out their own transactions, the very heart of what prices are supposed to do in a market.

Now some argue that some financial instruments, say a CDS contract, can’t be forced into clearing, since it would be unprofitable to post the margins and collateral necessary to clear. Your response should be: fantastic! This is an example of where sunlight is the best disinfectant. If an instrument trades only because people are uncertain about how it will ever get paid off, or if an instrument trades only because there’s an implicit (and nowadays, explicit) government guarantee of using taxpayer money, and without this guarantee nobody would be involved, then you don’t actually have a market.

Why is all this important? Well, as you might suspect, Mike says it's because it all comes back to the most pressing issue in systemic risk: Too Big to Fail:

The OTC market needs to change. To whatever extent it had problems before, the battle cry of “No More Lehmans!” has given everyone a perverse incentive to participate with Too Big To Fail banks. How can a small dealer compete in this new landscape?

... we can’t make Too Big To Fail progress without substantial new OTC derivatives regulation. Living wills, et al only make sense in the context that counterparty risk is more clearly defined, and that the playing field is leveled for more players.

I believe the prosecution has concluded its summation. Do we have a response from the defense?

Related reading:
Rortybomb: EoC On The Lynch Amendment (December 17, 2009)
Rortybomb: An Argument for Exchanges and Swap Execution Facilities (December 17, 2009)
Economics of Contempt: The Lynch Amendment: Bizarre and Confused (December 15, 2009)

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