New CFTC chair Gary Gensler provided a much more detailed description of the administration's OTC derivatives reform proposal on Thursday. While we still don't have nearly enough information to render judgment on the proposal, let me just say that I'm extremely impressed so far. The administration—by which I primarily mean Tim Geithner and Gensler—seems to be striking exactly the right balance. While they could still go off the rails on any number of unresolved issues, you get the sense that they understand the derivatives markets too well to make any calamitous mistakes. Obviously, a description of a new regulatory regime for OTC derivatives that's only 9 pages long is going to generate a lot of questions from the law firms. (I have a treatise on derivatives law and regulation that's over 2,000 pages long, so it's fair to say that Gensler's description leaves some things out.) On a first read, the one question that jumps out at me as the most important is how the CFTC plans to use the authority to impose initial margin requirements on off-exchange customized derivatives. Are they planning on reviewing every customized derivative prior to settlement to determine whether initial margin requirements are needed? In other words, will dealers be required to get a green light from the CFTC on initial margins before they can settle a customized trade? I highly doubt this is what the CFTC has in mind at this point, but when you consider the scheme the proposal sets up to make sure that derivatives that aren't cleared by a clearinghouse are truly "customized," things get a bit murkier. Presumably, off-clearinghouse derivatives can only be duplicated so many times before the CFTC deems them to be "standardized" and requires them to be traded through a clearinghouse. But if that's the case, then there would only be very limited circumstances in which the CFTC would ever impose initial margin requirements on a customized derivative—that is, unless they're planning on reviewing every customized derivative prior to settlement. Of course, that would likely be incredibly cumbersome, and could easily kill the bespoke market. Anyway, that's the question that really jumped off the page at me. Aren't you glad you don't do this for a living?


Anonymous said...

Actually, reading your blog has made me wish I'd gone into law. It's something I've always considered but never been willing to put on the table.

Of course, I recognize that being interested in the details and actually being willing to make them one's career are two very different things

Don said...

"Lower Systemic Risk. This dual regime would lower systemic risk through the following four measures:

Setting capital requirements for derivative dealers;

Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);

Requiring centralized clearing of standardized swaps; and

Requiring business conduct standards for dealers."

The basic answer is higher capital requirements. Since many of these investments were used to invest with lower capital requirements, raising the requirements should solve the problem. But do they? As far as Systemic Risk is concerned, I don't see how.

In a Calling Run or Flight to Safety, assets get revalued. In our current crisis, this happened very quickly. Some assets lose a lot of value as others gain. Many of these investments will, by their nature, lose value in a Flight to Safety. The problem then becomes one of price. People who own the investments don't want to sell in a panic, while people who would buy them will only pay low prices, since, in a Flight to Safety, they're simply not worth that much. Hence, there's a big gap between buyer and seller. Will this legislation solve that? I don't see how.

Obviously, I see what just occurred differently than other people. It was not the complexity of the investments that caused them to freeze, but the inability to come to an agreed value that caused them to freeze.

Systemically speaking, the answer is to avoid a panic, calling run, flight to safety. This can only be done with appropriate government guarantees. The amounts of capital being considered would not stop a panic. The real problem is how to construct a government guarantee that leads to forestalling panics, not causing them.

I don't mind the legislation, but I do not accept the role of these products in our crisis that others do.

I know my view is odd, but I hope that I was at least clear.

Don the libertarian Democrat

Anonymous said...

Wouldn't it be possible to set as a base case some minimum margin requirement: e.g. a tiny fraction of the contract's maximum possible loss. For contracts that fall into well defined categories (e.g. value depends only on interest rate fluctuations) it should be possible to set a more effective minima.

Economics of Contempt said...


Sure, OTC derivatives reform won't do much to mitigate the risk of another run on non-depository institutions, but it's not supposed to. Systemic financial stability is an issue for a separate regulatory reform (i.e., the creation of a systemic risk regulator).

I don't think OTC derivatives caused the financial crisis either -- in fact, I'm positive they didn't. But they definitely contributed to the crisis. The opacity of the OTC derivatives markets stoked a LOT of fear back in September/October, and that was definitely detrimental. Some public reporting standards have to be imposed. OTC derivatives are way too important to the smooth functioning of the financial system for investors to not have ready access to at least some meaningful market data.

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