derivatives-1433-95575642

Defusing Derivatives

By | Updated June 3, 2014

They made bankers billions of dollars before helping to blow up the global economy in 2008, living up to Warren Buffett’s description of derivatives six years before as “weapons of financial mass destruction.” After the crash, regulators set to work to make them less dangerous, through changes that in the process would make them less profitable. That set off a lobbying war on a titanic scale. Regulators say they succeeded in fundamentally altering the $633 trillion over-the-counter derivatives market, moving most of the trades onto open exchanges that take the place of the private dealing that was the norm. Critics say the new trading structure isn’t  as competitive as the government first hoped. And nobody knows whether the dangers were truly put to rest or just shifted elsewhere.

The Situation

Financial authorities around the world have been working to revamp the often-opaque markets that collapsed in the financial crisis, of which derivatives were the largest. Regulators want to be able to know what derivatives are trading, who is trading them and what the potential risks are. In the U.S., beginning in the fall of 2013 most derivative trades were shifted from phone calls or instant messages onto open, regulated exchanges or similar systems called swap execution facilities; the trades are publicly recorded in what are called data warehouses. Most contracts are now also backed by clearinghouses that require traders to post money as a cushion against losses, and mandate that clearinghouse members, mostly banks, set aside sufficient capital to share the risk. Not all trades go through this system. After vociferous lobbying, companies that can prove they are solely hedging a risk related to their main business are exempt. The European Union adopted a similar approach, though bankers complained it was more cumbersome, and differences between national regulations added to initial confusion. European and U.S. regulators still have plenty of cross-border issues to work through. The changes did not lead to a big drop in the market share of the largest banks, although some new companies have set up exchanges, including Bloomberg LP, the parent company of Bloomberg News.

 

The Background

Since the early 1980s, swaps have been used to insure against, or speculate on, movements in currencies, interest rates, corporate bonds and other instruments in trades arranged privately between a dealer bank and its customer. Prices varied from bank to bank and buyers of these derivatives could never be sure they were getting the best value. As the volume of contracts ballooned, they ensnared banks in a web of interconnections, as dealers made trades among themselves to offset risks from other deals. American International Group, the largest U.S. insurer, for instance, made hundreds of millions of dollars selling derivatives to banks, taking on risks from their transactions.  That aspect of the market, which had escaped regulators’ notice, threatened calamity when global markets plunged in September 2008 and AIG found itself facing huge losses it couldn’t cover. Fearing that AIG would collapse and take Goldman Sachs and other banks with it, the government bailed it out for $182 billion. Even so, trading ground almost to a halt. Without information on who held what swaps, banks could only guess at the financial health of their counterparties. The derivative trades that had brought Wall Street so much cash came close to being its undoing.

 

The Argument

The big banks that dominate derivatives still consider the new trading rules unnecessary, and have warned that the clearinghouses themselves could become the new too-big-to-fail entities. (The U.S., perhaps in response, has given the clearinghouses emergency access to Federal Reserve borrowing, just like the big banks.) Consumer protection advocates and some labor unions say that the largest global banks and their corporate allies weakened the law by carving out too many exemptions and that the system is still vulnerable. Regulators reply that they lost some battles but won the war by moving most, if not all, swaps out of the shadows.

 

The Reference Shelf

  • A joint regulatory report by the Bank for International Settlements and the International Organization of Securities Commissions on financial market infrastructure has a thorough overview of swaps issues.
  • A breakdown of derivative types by amount from the Bank for International Settlements.
  • timeline of global regulatory dates
  • An in-depth look by Bloomberg News at clearinghouses and how they manage risk, as well as the risk they now may pose to the broader financial system.
  • An outline of the Commodity Futures Trading Commission’s areas of responsibility under Dodd-Frank.

(First published Nov. 12, 2013)

To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net

To contact the editor responsible for this story: John O'Neil  at joneil18@bloomberg.net