Treasury Proposes Derivatives Regulation

Well it’s only been what eleven years since Long Term Credit almost brought down the financial system and the world was introduced to the word “derivatives.” They were a brand new concept back then and appeared to take the entire financial system, or at least the regulatory arm of that system, by surprise. A few voices were raised in favor of regulation but as the crisis receded and the good times started to roll it was quickly forgotten.

Now your local bartender is ¬†likely to engage you in a conversation about derivatives and their roles in all of the evils that beset the country. That doesn’t mean he understands them, but he knows they exist and someone on talk radio or CNBC or at the bar has told him that they’re the reason business is down and the highrollers aren’t leaving tips like they used to.¬†

But that’s OK because after all these years, it’s pretty obvious that not even the smartest of the smart, the guys who developed these things, truly understand how they work once they get into the system. It’s sufficient that the bartender knows about them and that they’re possibly evil because that neuters the case against regulation. Congress knows that it’s not fighting Wall Street alone now that it’s finally ready to apply some constraints to derivatives.

The Obama administration fired the first shot this afternoon. They apparently have all of the regulatory players somewhat on the same page and want to see the products under the thumb of a central clearinghouse.

The recommendations also call for requiring products that are standardized and eligible for trading through a central clearinghouse to go through one. A central clearinghouse is intended to eliminate risk from the system. One of the issues that arose during the credit crunch was that regulators and counterparties at times didn’t know the full exposure of a contract.

The Obama proposal would still allow for customized contracts that don’t qualify for central clearinghouse, but would seek to impose closer oversight of the dealers and institutions that trade such products.

The draft letter says that all over-the-counter derivative dealers and “all other firms whose activities in those markets create large exposures to counterparties” should be subject to “a robust regime of prudential supervision.” The draft letter calls for regulators to impose reporting and margin requirements on these dealers.

Personally, I’d prefer that they didn’t allow for customized contracts. Mandate standardization, get them into a clearinghouse and then figure out once and for all how they work systemically. One of the few benefits from this recession will probably be a large body of work that quantifies the effects of derivatives. Combine that with a couple of years of watching them trade in the sunlight and then move forward with bespoke contracts if it makes sense. Letting them continue to exist outside of a clearinghouse now is approaching the problem backwards.

Look, I’m not a Luddite. I do think these things probably have a place and an important one in the financial system. But they’re powerful things and a little knowledge about how you control them isn’t all bad. Come on, eleven years ago we had our first glimpse of how badly wrong derivatives can go. Like a driver who survives a tire blowing out at high speed, we put a retread on the car and continued speeding only this time a couple tires blew and we’re recovering from the injuries in intensive care. This time let’s put some good rubber on and take it slow and easy for awhile.

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