US financial reforms Bill: reining the over-the-counter derivatives markets

The scale and scope of the US sub-prime mortgage crisis has been such as to have shaken the US government of its slumber and move to tighten its grip on the financial markets in the country.

The scale and scope of the US sub-prime mortgage crisis has been such as to have shaken the US government of its slumber and move to tighten its grip on the financial markets in the country. The magnitude of the crisis can be gauged from the extent of losses following the crisis and the bailout packages doled out by major countries (refer to chart 1).

The agenda for regulatory reforms, drawn from the lessons of the financial crisis, before the US government, is large. A beginning has been made with the US Senate considering a 1,336-page Bill reforming the US financial markets. The Bill is aptly titled, ?Restoring American Financial Stability Act?. The preamble of the Bill reads as, ?A Bill to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ?too big to fail?, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.?

Thus, the primary purpose of the Bill is to promote financial stability of the US. This goal is sought to be achieved through various measures. Some of the important ones include:

* Setting up a Financial Stability Oversight Council (FSOC) to monitor emerging risks to US financial stability and recommend higher prudential standards for large, interconnected financial companies;

* Ending ?too big to fail? bailouts through the orderly liquidation authority.

* Prohibiting or restricting certain financial institutions, such as banks, bank holding companies and non-bank financial companies supervised by the board of governors, etc, from proprietary trading, sponsoring and investing in hedge funds and private equity funds.

* Creating Bureau of Consumer Financial Protection (CFPB), a new, streamlined independent consumer entity, etc.

One of the most significant proposals in the Bill is regarding regulation of over-the-counter (OTC) derivatives. To appreciate why taming the OTC markets is important, look at the chart presenting the derivative transactions on organised exchanges vis-?-vis those happening in the OTC markets.

As in June 2009, 90% of all derivatives trades were being executed OTC. Though OTC transactions have benefits of flexibility and innovation, they face problems of inefficient price discovery and large counterparty risk, as they are privately negotiated, devoid of novation which a clearing corporation offers. An IMF working paper of November 2008 attempts to quantify counterparty risk that may stem from the OTC derivatives markets.

It measures risk as losses that may result via the OTC derivative contracts to the financial system from the default or failure of one or more banks or broker dealers. It finds that considering that the notional value of all categories of the OTC contracts reached almost $600 trillion at the end of December 2007, the failure of a single major financial institution could result in losses to the OTC derivatives market of $300-$400 billion. The paper argues that since such a failure would likely cause cascading failures of other institutions, the total global financial system losses could exceed $1,500 billion.

Prior to the subprime crisis, OTC markets had proven to be fairly robust despite rapid growth of trading activity. However, the crisis exposed weaknesses. While central counterparties (CCPs) worldwide functioned relatively well, where such CCPs were not involved, there were difficulties in unwinding derivatives contracts. Bilateral clearing resulted in a proliferation of redundant overlapping contracts, exacerbating counter-party risk and enhancing the complexity and opacity of the interconnections in the financial system.

The Bill notes that interconnectedness of the country’s largest financial institutions through the unregulated derivatives market raised significant concerns about counterparty risk exposures during the sub prime crisis.

At the time of the crisis in December, 2008, the global OTC derivatives market stood at $547 trillion. Lack of transparency in the massive OTC market intensified systemic fears during the crisis about interrelated derivatives exposures from counter-party risk. With no requirements for margin or capital, OTC derivatives increased leverage in the financial system enabling traders to take large speculative positions on a relatively small capital base. Counter-party credit exposure in the derivatives market was seen as a major source of systemic risk during the failures of Bear Stearns, Lehman Brothers and AIG.

Recognising the ills of unregulated and risk management devoid OTC derivatives markets, the US government now proposes sweeping changes in the regulatory framework for OTC. The Bill proposes regulation of OTC derivatives by the SEC and the CFTC; requiring more transactions to be cleared through central clearing houses and trade on exchanges; subjecting un-cleared swaps to margin requirements and swap dealers and major swap participants to capital requirements; and reporting of all trades so that regulators can monitor risks in this complex market.

However, the Bill does acknowledge that some parts of the OTC market may not be suitable for clearing and exchange trading due to individual business needs of certain users. While permitting such transactions, it seeks to impose reporting, capital and margin requirements to serve as a monitoring tool and discouraging potentially risky activities.

The US financial reforms Bill is under consideration of the US Senate. What form the final Act would take remains to be seen. Further the Bill envisages lying down of elaborate rules for trading in OTC derivatives jointly by the SEC and CFTC. How the rules would pan out and how effectively they would address the concerns on OTC market activity, only time will tell. However, the move to regulate these markets is a step in the right direction.

This move is recognition of the growing importance of OTC markets in the international financial system and the fact that OTC transactions are capable of building complex networks and large counterparty exposures which could bring down hitherto considered ?too big to fail? financial institutions.

?The writer is OSD, SBU-EDU, National Stock Exchange of India Ltd, Delhi-Regional office

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First published on: 23-05-2010 at 21:37 IST