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Dueling Derivatives Op-Eds « The Washington Independent

This morning, Treasury Secretary Timothy Geithner published an opinion piece in The Washington Post. In it, he argues:

Ending “too big to fail” also requires building stronger shock absorbers throughout the system so it can better withstand the next financial storm. To do that, the Senate bill closes loopholes and opportunities for arbitrage, and it brings key markets, such as those for derivatives, out of the shadows. Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system.

Sen. Judd Gregg (R-N.H.) had a detailed opinion piece in Bloomberg on the same topic:

Congress’s aim for OTC regulation is to reduce systemic risk to the financial system by, at the very least, providing an efficient regulatory structure that reduces the frequency and severity of market liquidity problems.

By and large, the swaps market is a wholesale, institutional market where most trades are large, block-sized transactions. Mandatory exchange trading would reduce market liquidity and increase execution costs for the ultimate end-user of these swaps. Advocates for mandated exchange trading want to decrease bid-ask spreads, which would theoretically lower the cost of these products, but they fail to understand the market sensitivities.

Mandating real-time dissemination of swap transaction price and quote data will require market participants to announce their trading interests to the entire market and allow others to step in front of their trades, moving the market against their hedges. In such an environment, market liquidity for swap transactions will decrease dramatically, if not disappear altogether.

To unpack: Geithner and Gregg sound like they might be at (incomprehensible) loggerheads, but they are not actually saying very different things. Geithner wants to exchange-trade derivatives, making pricing and volume information open to the market. Gregg argues that if pricing and volume information are public, the market will react to that information, making certain trades more expensive or even impossible. Both agree that exchange-trading derivatives will reduce fees for Wall Street banks and provide transparency into the true cost of swaps and other financial instruments.

There is a backdrop to the two wonky op-eds: Derivatives are the newest battleground between Democrats and Republicans, reformers and Wall Street. The Obama administration is currently pressuring the Senate Agricultural Committee (which is writing the derivatives part of the legislation) to ensure that the rules aren’t so loose as to exempt many financial firms and non-banks from using the exchanges.

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