U.S. Regulators Wishing for the Derivatives Fairy

The U.K.’s Financial Services Authority (FSA) released a report on OTC derivatives market reformsin December. In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments. It recognizes the trade-offs involved. It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates. It recognizes the burdens of mandated clearing and the associated cash flow risks on end users. It advocates an increased reliance on data repositories (something I advocated in late-2008 for OTC derivatives, and for energy years before that). It identifies counterparty risk management as the key issue, and concludes that mandated exchange trading is unnecessary to address this issue, and an unwarranted attempt to impose market structures.

Its analysis of position limits is especially good. I liked this part:

The second limb of the Commission’s proposal is to give regulators the possibility of setting position limits to counter concentrations of speculative positions. Such an approach would go beyond the existing legislative remit in the U.K. and more importantly we have not seen evidence which supports such an approach. The U.K. regime applies its position management tools to all participants, without a specific emphasis on those that do not have a desire to hedge physical positions, or take physical delivery. We do not consider activity by financial participants to be de facto manipulative. We do not therefore consider that there should necessarily be a distinction made between “large speculative” and “large non-speculative” positions for the purposes of combating manipulation – the focus should be on combating “large positions that lead to manipulation” irrespective of whether they are held by financial participants or not.

And this:

9.20 Over the last two years, certain commentators and market observers have linked the growth in financial, or “speculative”, participation in commodity markets with recent significant price movements, particularly in oil.We recognise that this type of investor has impacted the nature of commodities markets as a whole, for example, as a result of different methods of trading and increased volumes.

9.21 However, the majority of academic studies and evidence do not support the proposition that prices have been systematically driven by this increased inflow of financial interest. Indeed the majority of commentators have concluded that commodity price movements cannot be solely attributed to the activities of any one class of investor and are principally attributable to market wide factors.We agree with these conclusions.

Proposals for combating price movements

9.22 The FSA’s regulatory aim (as defined by legislation) is on maintaining fair and orderly markets, not limiting price movements or volatility. In any event, we do not believe a case has been made which demonstrates that prices of commodities, or other financial derivatives, can be effectively controlled through the mandatory operation of regulatory tools such as position limits, whether on exchange or OTC. Analysis of market data where position limits are already in use suggests that this has not shown a reduction in volatility or absolute price movements compared to contracts where they are not.

9.23 We also consider that limiting financial participation more generally would hamper market efficiency. To use oil markets as an example, increased participation has brought significant benefits, such as greater depth and liquidity.

In contrast, on this side of the water, from the Chairman of the FSA’s U.S. counterpart, the CFTC, we get drivel like this. He’s said it all before. Arguendo ad AIG. Horror stories about interconnections. Completely misleading conclusions based on outrageously inappropriate analogies between impossible to price toxic assets like MBS-based CDOs and vanilla swaps. Assertions that end-users don’t know their own economic interests, and subject themselves to the predations of a “small group of derivative dealers.” (His comparison between buying an apple and the OTC derivatives market is especially idiotic.) Wildly misleading insinuations that clearing will reduce interconnections in the financial system. Similarly wildly misleading insinuations that OTC trades are not collateralized. (Before anybody says this about AIG (AIG) again, read the AIG Special Inspector General’s report. Please.) Egregiously misleading insinuations that failure of a clearing member “does not harm its counterparties.” (Then, pray tell, who eats the loss? The derivatives fairy?)

Ugh. What inanity awaits us when CFTC announces its position limit changes?

Overall, the Europeans are quite dismayed at the trajectory of regulatory and legislative initiatives here in the US. This dismay is documented in a coupleof articlesby Jeremy Grant in the FT. This quote is priceless:

Richard Raeburn, EACT chairman, said companies were looking for a “clear carve-out” from the clearing and exchange-trading requirements.

“My fear is that what happens in the U.S. will pre-empt the ability to be sensible over here,” he told the Financial Times.

Yes, Mr. Raeburn, be afraid. Be very afraid.