Adding Derivatives to the Regulatory Reform Stew

US Banker | August, 2009

Even as its previously announced proposals seem to be either treading water or listing—the Federal Reserve as the too-big-to-fail monitor, for example, or the Consumer Financial Protection Agency—the Obama Administration resolutely soldiered on last week in delivering a plan for regulating derivatives to Capitol Hill.

The White House’s idea is fairly simple and straightforward: over-the-counter instruments will have to be cleared through regulated clearinghouses, tagged with capital margin requirements.

The Securities and Exchange Commission and the Commodity Futures Trading Commission will share oversight of most derivatives, although one puzzling exception is banks’ derivative trading, which would be monitored by banking regulators.

More puzzling, at least to Keefe, Bruyette & Woods analyst Brian Gardner, is the absence of a ban on trading naked credit default swaps—CDS without skin in them. Gardner notes that restrictions on naked swaps—which are speculative sources of risk instead of hedges against it—got the nod from House Financial Services Committee chairman Barney Frank (D-Mass.) and House Agriculture Committee chairman Colin Peterson (D-Minn.), who committed to move such legislation through their respective bailiwicks.

The omission might be related to complaints by some in the financial sector that even standardized CDS are too “lightly traded” to require clearing, a stance that seems laughable when describing a market that has notional value that may exceed $30 trillion. After all, palladium, tin, lead, and other commodities not quite worth $30 trillion have active futures and options trading on exchanges.

Meanwhile, the European Union and the U.K. seem further ahead in the regulatory reform department. A side-by-side comparison of the Obama, EU, and U.K. proposals by Selwyn Blair, senior domain expert at risk systems provider FRS Global, shows that some changes have already been implemented across the Atlantic. The British have taken steps to strengthen liquidity rules, for example, and the EU has adopted BIS recommendations for tighter capital requirements for the securitization market.

Even though the U.S., the U.K. and EU, share a range of common goals, the G8/G20 goal of global cooperation seems nearly as distant as it did before the financial market meltdown, Blair notes. “There is no mechanism in place to take a world view. What is clear is that there is an intent and a desire to implement changes, but the ability to do so is quite variable.” Regulatory regimes will not look same worldwide. “I can’t see the U.K. or the Federal Reserve telling France what to do,” says Blair.