Problems with OTC Derivatives Market regulations

A detailed analysis of the reforms of financial markets since the onset of last financial crisis was conducted by Americans for Financial Reforms(@FinanReformNow) and the Roosevelt Institute (@RooseveltInst). They have published their findings in form of a book (download here). Here they have explained: where we are in terms of these reforms till now. They have also given reasons as to why there have been delays in these reforms and the problems with OTC Derivatives Market regulations.

Here is an extract from the book:

Unregulated derivatives played a major role in the 2008 financial crisis, making clear the need for reform. Indeed, consensus was reached quickly on the necessary feature of derivative market reform. !e quick consensus is especially striking in light of the many debates that continue to this day on the right direction for the reform of other components of the fInancial system. The consensus has its roots in the peculiar history of the derivatives industry in the U.S., which stretches back 150 years to the trading of wheat futures on the Chicago Board of Trade. Heading into 2008, the U.S. derivatives industry operated along two parallel regulatory frameworks and market structures. !e older of the two, the futures and options markets, was firmly regulated according to principles fashioned over the course of more than a century. The “new kid on the block” was the unregulated swaps market, also known as the over-the-counter (OTC) derivatives market. Originally carved out as a provisional exception to the long established rules governing futures markets, its unregulated status and different market structure were given firm sanction in the Commodity Futures Modernisation Act of 2000. The OTC derivatives market quickly grew to become the dominant segment of the derivatives market. It was this unregulated OTC derivatives market that played such a destabilising role in the 2008 financial crisis. Its older cousin, the futures markets, did not play a similar role, and, instead, provided a working example of a derivatives market operated under sound principles, which could be adapted to the OTC derivatives market.

Despite the consensus on direction, implementation of the derivatives reform has dragged along very slowly. At times, it seems as if it might stall out entirely. Why? Free things undermine the momentum provided by the quick consensus.

First, there are the economic interests tied to the specific market structure of the OTC derivatives industry. Operating outside of any regulatory framework, the OTC derivatives industry evolved a ramified set of crisscrossing business entities, extending from the derivative dealers housed in the largest banks to the associated brokers, technology vendors and customers of all types. Many of them can probably win a profitable place in a reformed market, but the transition creates important competitive dangers. For others, the transition defines away a good portion of their business, and they will not go without a right. All of them have worked to slow the reform.

Second, the uncontested status of the reform vision for the derivatives markets masks a remarkable diversity of attitudes among supporters of reform. For some, derivatives are esoteric financial instruments relevant to Wall Street traders but incidental to real business. For others, derivatives are inherently evil, rocket fuel for a casino economy rigged to benefit the few at the expense of the many. Only a small subset of supporters of reform affirmatively embrace a vibrant, well-managed derivatives market as an essential feature of a successful growing economy that benefits the whole population.

While this subset designed the vision of derivatives reform currently being implemented, they have not yet sold it as part of a broader vision of shared prosperity. !is divergence in attitude weakens the public case for reform.

Third, despite the clear consensus at a strategic level, some important details are yet to be worked out. !e crisis exposed the error in leaving the OTC derivatives market unregulated. It undercut the foolish claim that swaps were essentially different from other derivatives, and reminded us of what we already knew about how to structure healthy derivatives markets. But while swaps are not essentially different, some swaps—being customised or otherwise suited to a small base of customers—are ill suited to exchange trading and clearing. We would be in a better position now if, during the several decades when the market was evolving, we had moved in tandem to gradually tailor rules appropriate to these circumstances. This would have provided room to test and fine tune the rules. Having failed to take the time when we had it, the crisis forces us to act hurriedly now. Still, there is a practical limit to how quickly we can successfully devise some rules. !e process must be informed by experience.

This limit tests our patience, and the debates on these details endanger the consensus, providing opportunity for opponents of the entire reform project.The reform of the derivatives market lies along a clear track, but without much power or speed. The tracks laid out in the consensus architecture define a clear course forward, so that at this slow speed there is no danger of veering of course to the right or the left. But it is always possible that the train could start moving in reverse.

Hitesh Anand

I am a post graduate from Newcastle University, UK. I like studying and analyzing economic data and financial health of world.

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