Transparency is a buzzword that has been frequently used — and abused — in the context of regulatory reform.
The current Senate bill is founded on the notion that "100% transparency" can only be accomplished by moving all derivatives and foreign exchange trading to exchanges and clearing houses regulated by the CFTC, with a further requirement that all banks move such trading to a separate entity. Such extreme remedies are unnecessary and misdirect focus from the key problems that led to the collapse of markets and financial institutions.
In concept, transparency should foster stable and liquid markets that enable market participants to execute transactions in a timely manner and at fair prices that facilitate bona fide investment or risk management goals, while enabling regulators to ensure that public interests are protected, and investors and creditors have adequate assurances that they have put their money at risk under fair circumstances.
In practice, key products, markets and participants have already achieved those goals or are in the midst of concerted efforts to do so. Foreign exchange is the strongest example of how transparency can be accomplished without undue regulation. For more than a decade the foreign exchange industry has accepted electronic execution and quotation systems that make market pricing visible to participants without enabling front-running or disclosure of proprietary trading strategies.
Markets for foreign exchange products are deep and liquid. Accusations of market manipulation and conflicts of interest have been rare and restricted to issues such as the triggering of barrier options, which are now subject to well-accepted market-practice rules. Counterparty exposure has been greatly reduced by netting arrangements, collateral provisions and clearing arrangements. Accusations of abusive conduct have been infrequent, as market-practice guidelines have addressed issues such as fair market pricing, financial transparency and counterparty relationships.
Banking regulators have worked with industry groups to achieve these results. Other products are proceeding down the same path.
Regulatory reform should embrace these developments without stifling existing and liquid markets.
The current proposals directed at derivatives and foreign exchange would not have prevented the most damaging results of the financial market crisis, nor will they cure them. Pushing such transactions into separate subsidiaries does not remedy risk: AIG's problematic trading took place under a similar arrangement. To meet clearing and separate entity requirements, bank holding companies may be forced to house a significant portion of their most liquid assets away from the bank itself. As burdens increase, liquidity may suffer and trading may move into entities and markets increasingly remote from U.S. regulation.
Ironically, if any of these results were to occur, current proposed legislation could undermine, rather than foster, meaningful transparency and the liquid markets that benefit banks, their counterparties, investors and the public.