Derivatives Trading Comes Clean in the Open: Mark T. Williams

The proposals to overhaul the financial industry have their critics, such as Republican Senator Judd Gregg, who say the $600 trillion private over-the-counter derivatives market needs only superficial repair. Why put such trading on a transparent exchange if nothing is broken?

Are we to assume that the Great Credit Crisis of 2008 didn’t occur, that unemployment didn’t soar to more than 10 percent, that trillions of dollars in capital wasn’t lost, that we haven’t waited 19 months for meaningful financial reform, and that credit-default swaps weren’t at the epicenter of the financial meltdown? It all happened, of course.

Gregg also argues that an exchange would decrease market liquidity even though exchanges actually boost such liquidity. Having real-time pricing data will also help market participants in making more informed decisions. U.S. policy makers need to have a firm grasp of the facts and lessons learned from the crisis so we create a better financial system. Flawed reasoning and misinformation will only sow the seeds for another crisis.

It is a hard fact that credit-default swaps, or CDSs, were a major contributor to this financial crisis. When these swaps were created in the 1980s they were designed to hedge risk. Quickly they gained popularity as a tool to take large speculative bets. As far back as 1998, Brooksley Born, then head of the Commodity Futures Trading Commission, crusaded for stronger regulation over the rapidly growing private derivatives market. The rationale used then -- and remains true today -- is that products traded in the light of day and under greater transparency help to strengthen financial markets. Unfortunately, Born’s well-founded advice was ignored.

Hiding Deals

At the 2007 market peak, American International Group Inc. was one of the dominant CDS bookies in the unregulated derivatives market. In short order, AIG sold more of these risky products than its capital position could support. Without a standardized exchange, there was no transparent way to monitor the level of risk taking or set uniform credit requirements to counterbalance risk-taking activities.

In less than a decade, AIG churned out more than $500 billion in CDSs, off-exchange transactions that weren’t fully visible to the market or financial regulators. CDS positions brokered by financial firms such as AIG, Lehman Brothers Holdings Inc. and others grew like a cancer, spreading across the global financial markets.

The full systemic impact of these unregulated derivatives wouldn’t be apparent until 2008. By then it was too late to avert financial disaster and the American people picked up the tab for a $180 billion AIG bailout. Not having an exchange for these derivatives weakened the market and most certainly increased the cost to taxpayers.

Basis for Growth

Historically, exchanges have provided the needed footing for the growth and strength of our financial markets. Contrary to what those such as Gregg think, exchanges help markets function better. In 1792, the founding of the New York Stock Exchange provided the market confidence that unlocked the capital flow needed to support a rapidly growing nation. In Europe, formalized exchanges can be traced back to the 1400s.

Exchanges -- whether for equities, fixed income, commodities or financial derivatives -- provide greater price discovery, transparency and liquidity. These attributes increase market efficiency and reduce transaction costs. If AIG and others had been required to trade on an exchange, the severity of the financial crisis would have been reduced.

Today’s private derivatives market is getting bigger, further building the case that capital markets would benefit from putting derivatives on a standardized exchange.

Simple Answer

So why the pushback from folks like Judd Gregg? The answer is simple: Transparency reduces trading profits for a handful of banks.

Even after the worst of the crisis has passed, the CDS market is a multitrillion-dollar business mostly controlled by banks such as Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley. The dealer margins associated with off-exchange derivatives are as much as double what they would be if they were traded on an exchange.

From a business perspective, it is understandable why the largest derivative dealers would lobby against regulation that could reduce their profits. But what’s at stake is the stability of our financial system and what’s best for the majority of market participants, not a dozen Wall Street banks.

A meaningful financial overhaul can’t occur unless derivatives are put on an exchange. A highly visible and liquid CDS market is a logical place to start. Adopting the exchange provisions in the Senate bill sponsored by Christopher Dodd is critical. Having a clearer view of what derivatives trade on exchanges will allow for better monitoring, help in systemic-risk oversight and ensure that our markets remain strong. When making policy, legislators need to put the country and market stability first, and the special interests of a small group of Wall Street bankers second.

(Mark T. Williams, author of “Uncontrolled Risk” (2010), teaches finance at Boston University School of Management. The opinions expressed are his own.)

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