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Derivatives Are Evil And Must Be Destroyed

Posted on 8/20/2009 in Industry by Mark S. Longo
Derivatives Are Evil
We are seeing a familiar refrain in the financial world these days. Regulators, politicians and even the financial media are jumping back aboard the "derivatives are evil" bandwagon.

Derivatives are a popular scapegoat for the ills of modern society. When commodity prices surged last year, the finger of blame immediately pointed at rampant speculation in the derivatives markets (see It's Time To Ban CEOs & Senators From The Derivatives Markets and The Rage Against Derivatives Speculators Is Unfounded for more information).

But the true backlash came later when the financial crisis paralyzed the global economy. Not surprisingly, the outrage once again turned toward derivatives. But this time the response was different. It wasn't isolated to a handful of grandstanding politicians and CEOs arguing about inflated commodity prices. It poured in from all segments of the marketplace as institution after institution collapsed under the weight of their own greed.

With oversight in shambles and risk management nonexistent, investors focused their frustration on the instruments that wreaked so much havoc on their portfolios. As their 401Ks melted away, even the investing public began howling for the blood of derivatives traders.

In the past, the attacks focused primarily on the derivatives sector as a whole. But this time the ire was directed at a lesser-known segment of the derivatives world - credit default swaps. What had been an arcane and little-known product was suddenly transformed into a synonym for corporate greed and recklessness. The OTC marketplace quickly found itself in the same regulatory crosshairs that had long targeted its listed counterparts.

Exposing The Cracks In The Dam
When a derivatives backlash erupts, it is typically short-lived. No matter what triggers the backlash (e.g., the Barings implosion, the backdating wave, the Crash of 1987, etc) another scandal inevitably steals the headlines and gives the derivatives market a welcome reprieve.

But the financial crisis was no mere blip on the radar. Its impact is still reverberating throughout all sectors of the financial world. Although the collapse of AIG and other institutions cast an unwelcome spotlight on the derivatives market, the outcome wasn't entirely negative. The attention awakened regulators, politicians and investors to one inescapable fact:

  • The U.S. Derivatives Market Is Fundamentally Broken 

An Antiquated System
Attempting to explain the inner workings of the U.S. derivatives market is akin to trying to explain a complicated mosaic from only a few feet away. The closer you get, the less sense it makes. The regulatory structure of the U.S. derivatives market stems from legislation that was written when our grandparents were in diapers. The enduring legacy of this antiquated legislation is an oversight system that is woefully inadequate for today's complicated marketplace.

One obvious example of this inadequacy is the great schism that still divides the U.S. derivatives market. Options traders currently languish under the absentee rule of the SEC. At the same time, futures traders enjoy the comparatively streamlined management of the CFTC. In an era when most modern economies have unified their regulatory regimes to foster global competition, the U.S. markets are hamstrung with a bifurcated regulatory scheme from the last century.

Regulator vs. Regulator
Although it has responsibility for most equity and index options, the primary regulatory mandate of the SEC is the securities market. As we have all witnessed in recent months, this bloated mandate is well beyond the scope of the SEC's limited staff and budget. Expecting such an overstretched bureaucracy to also regulate the intricate world of equity and index options is beyond the point of reason.

Options traders have complained about the failings of the SEC for decades (see SEC vs CFTC: There Can Be Only One and SEC vs CFTC: There Can Be Only One: Conclusion for more information). They argue that the options market is too critical, and too complicated, for its oversight to be a mere afterthought. Many believe that the lack of a specialized options/derivatives regulator has hampered innovation and crippled competition in the marketplace. As a result, more than few options traders have cast longing glances toward the futures pits.

When compared to the SEC, the CFTC is a relatively efficient and streamlined organization. They have a straightforward mandate and are responsible for a single marketplace. While options traders are envious of this simplicity, futures traders are understandably protective of their autonomy within the derivatives world. The last thing they want is to be brought under the control of a bloated bureaucracy like the SEC. Thus the great schism persists. 

Falling Through The Cracks
This bifurcated regulatory regime has lead to a host of problems. We've seen a number of promising products (e.g., single stock futures, listed credit derivatives, etc) simply fall through the cracks or end up crippled by the demands of dual regulation.

The problems become even worse when the oversight function falls victim to our antiquated system. The world witnessed this firsthand when AIG imploded under the weight of poor derivatives risk management. AIG fell into the same premium writing trap that destroyed Barings PLC and caused many other infamous derivatives disasters. The steady stream of income generated by repeatedly selling derivatives contracts (in this case credit default contracts) quickly overcame any sense of proper risk management. 

In a perfect world, AIG would never have been allowed to risk so much on one roll of the dice. But the critical function of oversight fell through the cracks of the great schism, this time with disastrous consequences.

Healing The Schism...?
The current regulatory proposals on the table attempt to address the numerous problems plaguing the U.S. derivatives market. However, many feel that these proposals do not go far enough. The administration's current proposal continues to split derivatives oversight between the SEC and the CFTC, despite numerous calls to merge the two entities into a single derivatives regulator (see the International Securities Exchange's Regulatory Reform Proposal for one example of how the SEC & CFTC could be merged).

Tackling The OTC Beast
Under the current proposal, the bifurcated regulatory system would be expanded to include additional enforcement powers for the Federal Reserve to assist in the regulation of OTC derivatives, particularly credit default swaps.

The administration's proposal would also force all "standardized" OTC derivatives volume onto exchanges and into clearing houses. "Specialized" bilateral contracts would remain off exchange, but they would incur significant financial costs for this privilege.

While this proposal attempts to eliminate the counterparty risk frequently associated with OTC contracts, the efficacy of these solutions is highly debatable. For example, the definition of "standardized" OTC contracts is intentionally left vague in the current proposal. The SEC & CFTC would have an additional six months after the enactment of the proposal to clarify the definition of  a "standardized' contract. With the letter of the law so unclear, and the financial ramifications so steep, regulators can expect an onslaught of regulatory arbitrage (a.k.a, gaming) to exploit the differences between "standardized" and "specialized" contracts.

It is also unclear whether forcing centralized clearing on the OTC market is even viable. While single name CDS contracts are relatively simple to aggregate and clear, many other OTC contracts do not easily fit into the current clearing models. Will clearing houses be forced to accept risky contracts that could jeopardize their traditional members? If so, will they enforce draconian margin requirements that would render much of the OTC market cost prohibitive? While many derivatives opponents would cheer such a prospect, destroying a vibrant source of risk management solely for the sake of rushed reform is hardly in the best interest of the marketplace.

The Future?
With competing regulatory proposals on the table, there is precious little certainty in the derivatives world right now. Unfortunately, this uncertainty has allowed more than a few critics to fall back on the old "derivatives are evil" refrain that has haunted this marketplace since its inception.

There are still a surprising number of opponents who deride the natural function that speculation plays in the derivatives market. Still others believe that certain products should be abolished altogether, despite their primary function as risk management tools. Even George Soros, himself no stranger to the world of derivatives, infamously referred to credit default swaps in the following terms:

  • "It's like buying life insurance on someone else's life and owning a license to kill."
With so much hyperbole and emotion at play, accomplishing actual reform in the derivatives market is a difficult task. It is encouraging that the administration is looking to repair this broken marketplace rather than destroy it in the name of a quick public relations coup.

Regardless of your views on derivatives, one thing is apparent to all sides in this debate. The derivatives market of tomorrow is likely to be a very different place from the one we know today.

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