A DERIVATIVE WATCHDOG’S DANGEROUS QUEST FOR PRECISION
Gary Gensler, the former Goldman Sachs (GS) partner now heading the U.S. Commodity Futures Trading Commission, has never been a dawdler. So it was unnerving to see the CFTC miss a major deadline for its biggest project: redefining derivatives markets to prevent a repeat of 2008-style mayhem.
The CFTC says it now needs until yearend to complete regulations that had been due in mid-July. Outside experts such as Darrell Duffie, a finance professor at Stanford University, think longer delays are likely. Meanwhile, Republican opposition is mounting, as seen by Kentucky Senator Mitch McConnell’s recent declaration that “anything we can do to slow down, deter, or impede” the regulators’ agenda would be “good for our country.”
The senator is wrong. The CFTC’s rulemaking efforts are needed to tame the largely unregulated market for over-the-counter derivatives, where $300 trillion of contracts trade in the U.S. alone. Such markets remain highly opaque; information about transaction prices, trading volume, and collateral is scant or outdated. Although it’s not unreasonable for the CFTC to ask for six more months, the agency should enact its core ideas by the end of this year. Fine-tuning can come later.
The CFTC’s road map so far is ambitious and intricate, involving 51 proposals. In some cases, the agency is trying to write such a detailed script for how markets should work that it isn’t leaving enough room for participants to sort out what structures will work best. As potential market participants have pointed out in comment letters (including Bloomberg LP, the parent company of Bloomberg Businessweek), allowing more flexibility could help get to the finish line faster.
To improve trade execution, for example, the CFTC is trying too hard to model new derivatives exchanges—they go by the balky term “swap execution facilities”—on existing stock and futures exchanges. Swaps aren’t like stocks, or even exchange-listed futures. Many are custom-made for one company; some are contracts that last for decades and rarely change hands. More important, there are few if any retail investors to protect in the swaps markets. To improve price transparency, a worthy model already exists: the Trade Reporting and Compliance Engine reporting system for corporate bonds. Set up in 2002, TRACE provides details of corporate bond deals within 15 minutes. Posting bond prices on the website of the Financial Industry Regulatory Authority effectively restrains bond dealers from charging customers excessive markups. A 2006 academic study concluded that trading costs declined by about 50 percent, saving $1 billion a year.
Market regulation is always a work in progress. Long delays at the CFTC wouldn’t just leave market participants in limbo; too slow a pace would also open the door for politicians to hobble the commission itself. Worse, allowing the perfect to be the enemy of the good risks another American International Group (AIG)-style crisis.
BRUSHING UP ON THE ECONOMIC BASICS
With the outlines of genuine progress toward a deficit-cutting deal on the horizon, it’s a good moment to review a few principles about taxing and spending.
Let’s start by acknowledging that supply-siders have a point: Any tax depresses the activity being taxed. Sometimes you want to use the tax system to affect behavior. (The cigarette tax is an example.) But in general, if you believe in free markets, you want taxes to change people’s incentives as little as possible. This means two things: Tax rates should be as low as possible, given the government’s revenue needs; and tax rates on different ways to use your labor or your capital should be as similar as possible.
Too much attention is given to the first of these considerations (low tax rates) and not enough to the second (consistent tax rates). In fact, Congress puts much energy into making the second factor worse, by the profusion of different tax rates and tax breaks for this and that. Every tax break for some industry or activity means higher taxes for everyone else. People who call for or defend such breaks—from tax credits for car buyers to the favored treatment for capital gains—are, in effect, saying they (and the government) know better than the market how best to allocate capital in the economy.
Even as the distribution of income in the economy has become skewed in favor of the well-to-do, the tax system has become skewed as well. We believe the tax system should be progressive, with people who have been more fortunate putting up a bigger share of the wealth. Getting out of the fiscal hole the U.S. has dug itself into, along with other nations that should have known better, will require not just “the rich” but also the middle class to pay more of their income in taxes.
Increasing numbers of Americans agree. According to a recent Bloomberg National Poll, more than 75 percent of those surveyed—Republicans, Democrats, and Independents—believe that an increase to bring down the deficit is inevitable. That could be resignation rather than conversion, but in any event, it’s a start. Many more people, we believe, would find this medicine easier to take if they had more faith that the money was being spent wisely.
In short, spending must also take a hit. And not just “waste,” either. On the spectrum between “nice to have” and “essential,” many Americans have moved their private spending closer to the latter. They want the government to do so, too.