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Don’t Shoot the Regulator: The Reforms Making Hated Derivatives “Friendly”

When the financial crisis hit in 2008, barely five minutes went by without hearing phrases like “toxic assets,” “credit default swaps,” all stemming, of course, from the dreaded “derivatives market.”

But a range of new proposals aimed at regulating the derivatives market could turn these misunderstood and oft-feared instruments into truly valuable financial assets for individuals and businesses alike.

Let me explain how regulation could open up this market, rather than stifle it…

Demystifying Derivatives

 

First, here’s the deal with derivatives…

A derivative is a financial instrument that delivers its return based on the movement of some underlying asset.

The most common example is a stock option. You don’t have to own the stock, but the price of the option contract will move when the stock does. When you use options, you’re essentially making a side bet with the person on the other end of the contract.

However, stock options, are practically an afterthought to the real derivatives market.

According to the U.S. Treasury, the notional value of derivatives held by U.S. banks stands at $231 trillion. But just 0.6% of that is equity derivatives like stock options.

And while derivatives got a dirty name after the financial crisis because of credit default swaps, they account for only 6.1% of the outstanding value. Foreign exchange contracts count for 9.1%.

The true bulk of the derivatives market centers on interest rate derivatives, which account for $193 trillion (83.7%) of the outstanding notional value.

To Swap or Not to Swap?

It’s important not to confuse credit default swaps with interest rate swaps.

While credit default swaps can cause problems when used recklessly, interest rate swaps provide real value to our financial system.

They seem complex, but the outcome is simple: An interest rate swap allows anyone to turn a variable rate payment (or collection) into a fixed rate payment (or collection). For example, a bank may notice it’s got a few too many variable rate loans outstanding. So instead of lending at a fixed rate, or recalling some variable debts, it can enter a swap.

That might not sound like a big deal, but consider that the bond market (which is so sensitive to interest rates) is actually three times larger than the equity market.

Now consider that any business that lends or borrows money (i.e. all of them) needs to manage its exposure to changing interest rates and you can see how the market has gotten so big.

Even so, a well-regulated and standardized interest rate swap market could create a wealth of benefits by reducing risk in the system.

Which is exactly what the Dodd-Frank bill aims to achieve…

This is One Area That We DO Need to Regulate

The Dodd-Frank proposals for derivatives are pretty basic.

At the moment, interest rate swaps trade in the shadows as customized over-the-counter contracts trade. Each swap has unique terms laid out in pages of dense legalese.

In this type of market, the interest rate risk simply switches to another. This is known as counter-party risk – the risk that the person on the other end of your swap won’t have the cash when its time to pony up.

Counter-party risk in credit default swaps essentially caused the financial crisis. For example, when AIG realized it couldn’t pay on all the swaps it had, the threat of defaults ripped through the financial system.

By nature, interest rate swaps already have smaller counterparty risks. But the Dodd-Frank bill proposes that instead of custom contracts seen only by the two parties involved, the contracts would be standardized, traded over an exchange, and passed through a clearinghouse.

The steps are simple. Impose capital requirements on counter-parties and require swap dealers to register with the SEC or the CFTC in order to reduce risk and improve transparency.

And this is where the anti-regulation evangelists have it wrong…

Regulation Opponents Have Lost Sight of the Free Market Concept

Wall Street executives continue to level attacks at the Dodd-Frank regulations, claiming that they’ll limit profits.

“It will stifle economic growth and I already believe it is,” says Jamie Dimon, CEO of JP Morgan (NYSE: JPM)

Sorry, Mr. Dimon. The only growth threatened by these regulations is your personal paycheck.

In fact, if you’re talking about the benefits to the economy, the Dodd-Frank regulations should spur economic growth and reduce systemic risk.

You see, while the idea that a free market always provides the best outcome has gained political momentum, the theory is based on the assumption of perfect market information, no participation with pricing power, no barriers to entry or exit, and equal access to technology.

And Wall Street has spent years deliberately trying to suppress those positive characteristics in the derivatives market because a lack of transparency helps boost profit margins.

So the Dodd-Frank proposals are spot on…

Let’s Call it “Reform,” Not “Regulation”

The truth is, with proper regulation and transparency, the derivatives market could expand wildly, allowing smaller institutions, small businesses and potentially individual mortgage holders to hedge their own risks.

And that will breed a new swap exchange that makes money on volume rather than predatory pricing. After all, SEC regulations didn’t stop the New York Stock Exchange from notching up a 14% profit margin last year.

The same principle could apply to a new derivative exchange. Someone will profit, except this time, it might not be the entrenched Wall Street powers. In addition, the profits will come fairly and for providing a true service.

Simply put, the Dodd-Frank bill doesn’t outlaw over-the-counter derivatives. Nor does it force them all to trade under the “Big Brother” government, or turn the markets over to socialists. Instead, it could turn dangerous derivatives into the useful, risk-reducing instruments they always had the potential to be.

Regulators face a difficult task developing measures that will work, but dismissing regulation out-of-hand as “evil” is what led to the financial crisis in the first place. Learn from it, or expect another one.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk