The last few weeks have seen a number of news stories indicating that the broad agreement reached by the G20 in early 2009 regarding the regulation of Over the Counter (OTC) derivatives is breaking down. On January 5th 2010, for example, the Financial Times titled ‘Cracks in transatlantic derivatives rules‘. In the UK, the Financial Services Authority and the Treasury published in December 2009, a report on regulation of these marketswhich, whilst couched in supportive language, made a number of criticisms of the Commission of the European Communities document on this topic published in October 2009 .
Meanwhile in the US, the US Treasury is aiming to achieve legislation on this topic; in Congress, the House has agreed a draft bill which differs again in some respects from both the UK and the EU and the Senate is due to consider the issue this month. Most recently, non-financial companies in the EU under the aegis of the European Association of Corporate Treasurers have protested strongly about some of the existing proposals in a letter addressed to the EU Commission on the grounds that they will financially penalize them .
The result is a somewhat confusing situation in which the danger is that regulation will not be coherent across the main financial markets and regulatory arbitrage will emerge, potentially paving the way for a further destabilisation of the global economy. Many of these debates and differences appear very technical but as I have sought to show in a recent article on ‘Legitimacy in financial markets: credit default swaps in the current crisis’ in Socio-Economic Review, underlying them are major issues of politics and power.
In the immediate aftermath of the Lehmann crash and the financial crisis which ensued, governments and regulators identified many features of the system which contributed to the problems. The trading of over-the-counter (OTC) derivatives was seen as particularly important. Derivatives are complex financial instruments that in theory enable firms to trade the risk associated with a specific phenomenon, e.g. the potential for interest rate changes, for exchange rate changes, for changes in the value of particular baskets of equities, the potential default of a borrower etc.. For non-financial firms, this is useful in terms of enabling them to fix future liabilities and therefore plan more with more certainty.
For financial firms, however, OTC derivatives became a hugely profitable business. Whilst many areas of this trade were relatively commodified, it was the more exotic products which were really profitable. In particular, as borrowing increased with low interest rates and huge global imbalances between high and low saving economies, financial institutions established the securitization solution to the continued expansion of credit. They packaged loans up and then sold them on to others, at the same time offering an insurance against default on these loans in the form of the credit default swap (CDS). The credit expansion of the period up to 2007 (which fuelled the asset inflation of the period, including house prices) was reflected in the scale of CDOs (collateralized debt obligations) issued. The risk of CDOs was offset by taking out CDS contracts; under these contracts, if the CDOs lost value, the CDS buyer was entitled to claim that loss back from the CDS seller.
CDS contracts were negotiated bilaterally, over-the counter. In a context where there was a general belief that the boom would continue – and therefore the asset prices on which the original loans were made would rise, ensuring that defaults would be limited – the issue of collateral (i.e. placing capital into an account to deal with a potential default) was treated with benign neglect. It was more likely to be present as a condition of the contract (in the sense that if a certain level of defaults occurred, then collateral demands would ratchet up quickly) than as a real constraint on trade. There were no regulators who had authority to insist on collateral. Both the UK (in the Financial Services Act, 1986) and the US in 2000 Commodity Futures Modernization Act) had explicitly ruled out any state regulation of OTC derivatives markets. The industry itself through its trade associationInternational Swaps and Derivatives Association (ISDA) was left to establish and monitor collateral; unsurprisingly these were relatively low and did not apply to all issuers of contracts.
When, therefore, asset prices fell and defaults increased, conditionality clauses in CDS contracts were activated and suddenly contract providers had to find large sums of collateral. In many cases these calls were beyond their ability and the result was that they hovered on the brink of bankruptcy (e.g. AIG) until governments rescued them. As asset prices plummeted, it became clear that nobody knew who was holding the ‘toxic assets’, how to price these assets in order to establish the size of the difficulty any firm holding them on its balance sheet faced, who was insuring these asset values via CDS contracts, how much these contract issuers might need to put into collateral or into compensating contract holders. Since the purchasers of the contracts were not confined to those holding the assets – anybody could buy a CDS on any securitised bond issue – the scale of the problem was magnified even further. In this context of uncertainty, banks stopped lending to each other and the financial system came close to complete collapse. It was only when governments reacted by guaranteeing banks and setting up various schemes to enable banks to borrow on the basis of toxic assets that the immediate crisis ended.
When governments moved from this necessarily ‘national’ response to the crisis to thinking about how to prevent it occurring again, they identified the OTC CDS market as requiring significant regulation. The general consensus was to move to a system of Central Clearing Parties (CCP). In a CCP system, instead of there being a bilateral contract between two companies, there are two contracts. The seller sells a contract to the CCP; the buyer buys the contract from the CCP. In this way if either party defaults, the risk falls on the CCP. The CCP is expected to demand appropriate collateral on each contract and to mark-to-market on a daily basis the collateral, thus varying the demands on the two participants as the value of the collateral itself moves and the value of the underlying assets change. As a result CCPs are expected to be able to have sufficient spare collateral that they can deal with defaults and thus stop problems spreading more widely. CCPs can also monitor the scale of contracts and the ways in which they are moving as they build up. In principle, therefore, it can provide information to regulators on the positions of particular institutions.
Whilst the CCP model may provide a framework for controlling the systemic effects of CDS contracts, it has a number of problems and these problems are not yet resolved in discussions between regulators.
Firstly, the CCP depends on the idea of a standardised contract. How much of current OTC CDS activity can be standardized? Since financial institutions are likely to make higher profits from non-standard contracts, they tend towards favouring more room for continued bilateral OTC contracts than most regulators. In this they are increasingly being supported by non-financial firms such as the 160 firms represented in the letter of the European Association of Corporate Treasurers mentioned earlier who wrote to the European Commission requesting that any new regulation not require them to put down collateral.
Regulators in different national contexts are committed to the CCP model. They are discussing the creation of a financial incentive for institutions to move away from OTC and into CCPs, by making a higher reserve requirement under Basle rules for capital risked on the OTC markets than in the CCP. However, industry groups are lobbying strongly on this and there is not yet a common line amongst regulators about issues such as the definition of ‘standardization’, the expected extent of non-standardized business activity, the degree to which participants in non-standardized contracts (i.e. the tradition OTC model) will be incentivized financially (by higher reserve and collateral requirements) to shift their business on to CCPs. There is a danger that if these definitions differ substantially across different national contexts, the result will be a form of regulatory arbitrage.
Secondly, there are a number of potential CCPs emerging in both the US and the EU. There are not yet common standards as to how a CCP should work . Issues such as the scale of collateral, the nature of standardised trading, and the responsibility of members for maintaining the solvency of the CCP have yet to be resolved. The UK FSA is lobbying for a European directive that will standardize the CCP model but there is no guarantee this will fit the US model. Again issues of regulatory arbitrage continue to loom large in contexts where uncertainty is high and differences appear to be substantial enough to have a significant impact on profitability.
These debates reflect the difficulty of getting agreement across borders even in situations where this appears essential in order to prevent the potential occurrence of a further financial crisis. Regulators engage in multiple networks of discussions and negotiations in order to seek to achieve some sort of consensus. The latest FSA paper, for example lists, in Annex 2, twelve ‘international regulatory workstreams’ associated with the issue of regulating OTC derivatives. These workstreams involve representatives of national governments, international organizations and industry organizations operating in a variety of arenas working at different time-scales on inter-related aspects of the problems. Solutions are likely to emerge slowly from such environments.