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A Derivatives Expert on Derivatives Reform « The Washington Independent

The Hill is eagerly awaiting the full text of the proposal by Sen. Blanche Lincoln (D-Ark.) to regulate derivatives. The legislation reportedly requires most derivatives to be processed through clearinghouses and for investment banks to house “swap desks” outside the bank, or otherwise to lose access to the Federal Reserve’s discount lending window and F.D.I.C. deposit insurance, among other provisions.

To discuss the proposal, I spoke with Robert Litan, a senior fellow at the Brookings Institution and the vice president for research and policy at the Kauffman Foundation. He recently published a paper offering optimal policy solutions to regulate derivatives without over-dampening the market.

**I’d be interested in your reaction to the derivatives proposal put forward by Lincoln. It hasn’t actually been released yet, but we have some details about it the general ideas. What do you think thus far? **

I have a couple reactions. If I had my druthers, I wouldn’t force derivatives onto clearinghouses and exchanges. I’d use capital charges as an incentive to get companies to use them instead.

I have a section in my recent paper that argues that regulators aren’t the best judge as to what should be cleared and not. But Lincoln’s proposal, as well as the Dodd and House bills, have mechanisms to force things onto clearinghouses and exchanges. There has been some criticism of the proposals from the other side, but I’m not sure that Republicans support the incentive-approach either. Maybe they’ve made the the political calculation that this is what’s necessary. But, if I were writing the bill, I’d be using capital charges rather than requirements.

The second point is that she wants to cut off the derivatives desk and put it outside the bank. I worry about that, because it is possible, not necessarily certain, but possible that you could seriously crimp the market before it gets going. That is because one of the reasons end users deal with banks for derivatives trades is that they treat them as too big to fail. The reason, if you’re a company making a swaps deal, that you go to Goldman Sachs is that you think that they are going to honor that contract, no matter what happens. But if rather than going to Goldman Sachs, you’re going to an affiliate, you might think again. And that means that on aggregate we might end up with less derivatives traffic.

The counterargument to that is that when, say, Bank of America sets up a derivatives affiliate, the counter-party might assume that the affiliate is part of the too big to fail organization and nothing changes. That’s likely. But if that is the case, there’s a presumption that we’ll end up bailing out the affiliates. That means, there would have been no point to moving the derivatives portions out of the banks to begin with. Maybe what that’s what Congress wants to do. But I’m nervous. It really could disrupt legitimate derivatives activity.

Finally — again, if I had my druthers — I’d put in more emphasis on incentives for clearing and trading. I don’t think the bills touch it at all. I haven’t looked closely enough and the fine print, and I’m not sure we even know yet. But it seems the bills don’t touch it at all. Right now, prices for derivatives in question, those are end-of-the-day prices. They aren’t actual prices. They’re just averages from the day before. So, we have little pricing transparency in this market. And I’d want the regulators to have more authority to push for much more frequent reporting of transaction prices. It is conceivable that the authorities could push dealers to do that — but I don’t know if it will assure us that we’ll get real-time pricing. That’s absolutely critical.

Right — and presumably on the buy-side, purchasers of derivatives, would want more pricing information via exchanges or clearinghouses, rather than over-the-counter deals, too. Say you’re Cargill, or some other company that purchases a lot of derivatives. Wouldn’t you presume that the pricing information will drive your costs down, even if the regulations require you to put some capital up?

I think the buy side would love that transparency. Right now, if you’re Caterpillar, you rely entirely on the price quoted from the bank or from the day before. You can’t go look up the price on a Bloomberg terminal. You can see what the average price was yesterday — but that really isn’t a price.

The next day is a new day. Things change. So, when you call your broker, they say, “Well, I’ll get back to you.” Or, “Here’s the price, but it’s not a firm price. Give us your business and we’ll confirm the price to you, and we’re promising we’re getting you the best possible deal.”

That leads to the next question, which is the end user-exemption. It seems that’s going to be a big fight. I know the Caterpillars of the world don’t want to go onto central clearing now — they don’t want to pay for it. My view is that if you had significant capital charges on non-cleared derivatives, that would induce the dealers to try to get these transactions into clearinghouses, and it would induce the buy side. Because if dealers have to have substantial capital behind buy-side trades, they want the transactions to become standardized and go through clearinghouses, and it will be cheaper for the buy side. I’m not that sympathetic with the broad end-user exemption. I think they ought to go through central clearing. But that is not something that the Lincoln or Dodd bill seems to do now.

Still, we just don’t know enough details. The details are really important. But right now, the buy side seems to want out. They don’t want to have to post collateral. But we’ll know more on that.

As it is now, I agree, and I’m confused as to why there is so much end user opposition to this bill. You would think that firms would want to pay less for these deals even if it meant putting up capital.

Absolutely. If we get central clearing, that is a predicate to exchange trading, which will necessarily reduce the spread and bring prices down. That is the logic. You have to ask: Why is it that some of the big guys don’t recognize that?

I only have a couple theories — I don’t know for sure. One theory is that they just don’t trust or don’t believe the regulatory process will bring us to that brand new world of exchange trading. They do not trust it will happen, and therefore are more comfortable with the world as it is. Then, if exchange trading does happen, they do not believe there will be a compression in the spreads, contrary to all of financial history. The stock market shows us that spreads massively narrow when exchange-trading is put in place. So, they just don’t trust or believe this is going to happen, for some reason.

Another theory is that in effect they’re doing the dealers’ bidding, and the dealers have enormous incentives to keep the current system under place as well as leverage over their clients. My understanding if that you’re a big buy-side user, you don’t spend time a lot of time shopping between Goldman Sachs, J.P. Morgan, Morgan Stanley. You just have your favorite dealer. In a world of non-transparency, the world the derivatives market is in right now, the way I understand it, if you try to call four or five dealers, to shop around, none give you a real price. They might quote you an indicative price. If you commit, then they give you pricing information.

So, since now, you have a favored dealer, you’re worried that if you come out in public and say you want clearinghouses or exchange trading, until that is in place, you are concerned that you will offend your dealer, and you aren’t going to get good terms. Because, as it is, buy a derivatives contract, it isn’t like walking into WalMart and looking at the sticker price. Maybe, if you take a public policy position contrary to your dealer, you might not get that favored treatment.

I have no basis for making those claims, I’ll note. Those are just plausible, rational explanations.

Then, there’s a third reason which makes the most sense. And that is — well, it makes sense in the short run. There is a classic collective action problem here. Nobody wants to pay to make the system safer for everybody. It’s like taxes. I don’t want to pay for defense, I want you to pay for defense. If I can get you to pay, then, I get a free ride.

So, as it is, since these companies might be getting good deals now. Their costs will go up at the beginning when they have to start posting collateral. If the system evolves over time, we’ll get to that nirvana with clearinghouses and lower spreads. But if these companies are just thinking about the short term, they might oppose the change. That’s a short sighted but semi-rational thought process. And it’s just people acting in their own interests.

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