Wednesday, May 5, 2010

Not Quite Ready to Damn Derivatives

As a result of their role generating significant economic losses during the recent financial crisis, it is not surprising that there is a dearth of credit derivatives defenders. Few publicly disagree with demands for increased regulation of credit derivatives or dismiss as populism cries for increased transparency and oversight. Republicans, in a reversal of strategy, have hitched their efforts to thwart adoption of financial regulation to a “We-Want- Even-More-Regulation” battlewagon.

Interestingly, last week, a senior bank regulator and appointee of the Democratic administration expressed concerns that regulation as currently proposed threatens to drive use of derivatives into the shadows, an approach that may present more of a threat to future economic stability than structuring regulation in a manner that maintains a spotlight on the use of these instruments. In her letter to Senate Banking Committee chairman Christopher Dodd, D-Conn., and Agriculture Committee Chairwoman Blanche Lincoln, D-Ark., Sheila Bair urged caution in the Senate’s approach to regulating derivatives.

According to Ms. Bair, the chairwoman of the Federal Deposit Insurance Corp., Inc., legislators should tighten the reins on derivatives but avoid choking the industry. The current proposal for regulation of derivatives requires standardization of derivatives and compels exchange trading or trading these instruments through clearinghouses. By failing to include provisions for a broad enough range of alternatives or regulator flexibility in addressing customized derivatives products, Ms. Bair argued, “the underlying premise” of the proposed legislation suggests “that the best way to protect the deposit insurance fund is to push higher risk activities into the so-called shadow sector.” Ms. Bair argued against overly restrictive regulation on two grounds; first, derivatives offer an important risk management tool for banks and second, not all derivatives are created equal. After expressing “strong support for enhanced regulation of ‘over-the-counter’ (‘OTC’) derivatives and the provisions of the bill which would require centralized clearing and exchange trading of standardized products,” Ms. Bair explained that certain uses of OTC derivatives, such as bank’s use of derivatives for interest rate hedging, offer valuable tools for banks to manage risk in an environment where “uncertainty surround[s] future movements in interest rates” and failure to hedge may have detrimental effects on “unhedged banks.”

Is it that simple to distinguish among parties’ varied uses of derivatives? Distinguishing “good” and “bad” uses of these instruments may be more elusive than Ms. Bair suggests. The recent crisis illustrates that banks and bank holding companies should not be permitted to engage in activities that create substantial risks of solvency-threatening liquidity crises. The difficulty with Ms. Bair’s position and most other voices offering direction on how to regulate derivatives centers on the challenge of identifying “speculative trading.” Many point to naked credit default swaps as an example of the type of speculation that should be banned. The agreements are described as a mechanism for gambling. Is this characterization completely accurate? Are there any uses of credit default swaps or naked credit default swaps that offer strategic value beyond hedging against risk? Is risk-reduction the litmus test for determining the social value of investment products? If there is a distinction between hedging and speculation, can we articulately describe it? It seems we must agree on broader national questions about the social value of investing in order to reach acceptable answers to several of these questions.


  1. One recurring theme that surrounds the regulation of derivatives, particularly a new mandate on clearing and standardization, is that regardless of whatever new regulation occurs, financial innovation will flow to the next unregulated trading arena. If derivatives are regulated to the point that Bair fears, choked to the point of uselessness in hedging, then firms will just figure out new or different areas to exploit or hedge against loss.

    Are we not at a place where derivatives will surely become tightly regulated and we now need to turn our attention to the next great unregulated bubble?

  2. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). To know more about interest rate hedging Click here.