The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens...

8/7/2019 The Derivatives Dealers Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Inter

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The Initiative on Business and Public Policy provides analyticalresearch and constructive recommendations on public policy issues affecting

the business sector in the United States and around the world.

The Derivatives Dealers Club andDerivatives Markets Reform:

A Guide for Policy Makers, Citizens and Other Interested Partie

Robert E. Litan

APRIL 7, 2010


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THE US FINANCIAL AND ECONOMIC CRISIS: WHERE DOES IT STAND AND WHERE DO WE GO FROM HERE?

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CONTENTS

Introduction 3

Executive Summary of the Essay and its Central

Recommendations

4

The Ultimate Objective 5

Where We Are Now 6

Proposals for Change 7

Resisting Change: The Derivatives Dealers Club 8

Summary of Recommendations 10

A Cliffs Notes Guide to Derivatives 12

Swaps 14

Swaps (Primarily CDS) and Systemic Risk 16

Recent Derivatives Market Reform Initiatives: Public andPrivate

19

Administration and Congressional Reform Proposals 19

Reform Initiatives of the New York Fed 23

Why Not Ban/Restrict CDS Speculation? 26

The Derivatives Dealers Club 28

Dealing with the Club 33

Conclusion 38

Copyright 2010 The Brookings Institution


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Introduction

ention the word derivative outside of anarrow circle of Wall Street and Chicagotraders and other market participants, and

youre likely to get one or several of the

following reactions: fear, anger, or disinterest.Warren Buffett has famously analogizedderivatives financial instruments whose valuedepends on and thus is derived from the valueof some other underlying security, such as astock or a bond or the current price of acommodity as financial weapons of massdestruction. Who wouldnt be afraid of suchthings? Or, if the widespread condemnation ofderivatives for causing or helping to cause therecent financial crisis is accurate, who wouldntbe angry at them? Meanwhile, those who mightnot care about the word or the complex issues it

raises can be forgiven. After all, derivatives aredifficult for non-experts to understand and seemunrelated to every day things most people reallycare about in times like these such as their jobsand how they will be able to pay for theirchildrens education or their own retirement.

But whether you know it or not (or care),derivatives have become crucial parts of thefinancial and economic system not only in thiscountry but elsewhere around the world.Derivatives such as futures and optionscontracts, and various kinds of swaparrangements (involving interest rates, foreigncurrencies, and loan defaults), provide efficientways for both financial and non-financial usersto hedge against a variety of financial risks. Thenumbers involved run into the hundreds oftrillions of dollars in notional amounts, thoughthe amounts actually at risk are substantiallylower. Moreover, when properly used andbacked by sufficient collateral, derivatives havebecome a valuable financial tool for banks andwide variety of end-users: corporations andprivate companies, state and local governmentalentities, and so-called buy-side non-bankfinancial institutions.

Derivatives got their bad reputation during thefinancial panic in September 2008, when theworld learned that if the parties to both sides ofthe transactions are large, financially connectedwith many other parties, and do not have thefinancial means to make good on their promises,derivatives that are traded over the counter(OTC) and not centrally cleared can pose

dangers to entire economies. The dangers areespecially great for one kind of derivativecontract on which I concentrate primarily here credit default swaps (CDS). With CDS, non-

defaulting parties (the buyers of this particularkind of insurance against loan or bond default)are likely, especially in an economy-wide crisis,to find it more expensive to replace theircontracts with the defaulting party (the seller)than are non-defaulting parties in other OTCswap arrangements. Indeed, mainly for thisreason, unless otherwise indicated, when I referin this essay to derivatives I mean specificallyCDS, although many of the arguments or claimsI advance refer to other OTC derivatives aswell.1

Fortunately, there is a growing consensus amongfinancial regulators and academic experts aboutwhat to do at least with respect to standardizedderivatives, or those that resemble readily tradedstocks or futures contracts, and thus how to helpkeep financial actors who are heavily engaged inderivatives activities and also run into financialtrouble from infecting other institutions andconceivably entire markets. I will outline thisconsensus shortly, which may be enacted insome form by Congress this year as part ofcomprehensive financial reform.

I have written this essay primarily to callattention to the main impediments to meaningfulreform: the private actors who now control thetrading of derivatives and all key elements of theinfrastructure of derivatives trading, the majordealer banks. The importance of thisDerivatives Dealers Club cannot beoverstated. All end-users who want derivativesproducts, CDS in particular, must transact withdealer banks. The dealer banks, in turn, transactheavily with each other, to hedge the risks fromtheir customer trades and somewhat lessfrequently, to trade for their own accounts.

1In addition, many of the reforms of derivatives markets thatI discuss in this essay do not refer to customized contracts,but rather only to standardized derivatives. As discussedbelow, corporate customers of the large bank dealers aremore likely to have a greater need for non-standardderivatives involving interest rate or foreign currency swapsthan they do for protection against loan defaults, or CDS,which typically have standardized terms.

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I will argue that the major dealer banks havestrong financial incentives and the ability todelay or impede changes from the status quo --even if the legislative reforms that are now being

widely discussed are adopted-- that would makethe CDS and eventually other derivativesmarkets safer and more transparent for all

concerned. At the end of this essay, I will outlinea number of steps that regulators and possiblythe antitrust authorities may be able to take toovercome any dealer resistance to constructivechange.

Executive Summary of the Essay and its CentralRecommendations

or readers who want the bottom lines rightnow, I provide them in this initial ExecutiveSummary. In the body of the essay itself that

follows I begin by giving readers a briefoverview of the basics of derivatives, theinstitutional characteristics of the markets in

which they trade, and both their benefits andrisks. I then turn to the major reforms now beingconsidered by the Congress and that regulatorshave suggested or have been urging to reduce the

risks of OTC derivatives. I am uncomfortable,however, with one set of reforms that somehave urged to reduce systemic risks inderivatives -- a ban or severe restriction onspeculative purchases of derivatives, nakedCDS in particular, and outline those concerns in

a separate section.

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The Ultimate Objective

he rough consensus about how to makederivatives market safer and more transparentcontains the following features (If some of

the following terms are new to you or seem

vague, please wait, Ill be explaining them in thetext of the essay):

-- Induce or require standardized derivatives tobe cleared on central clearinghouses ratherthan handled by dealers, acting on behalf of eachof the parties (the buyer and seller) to thesecontracts.2

--Establish the conditions that will inducederivatives that are centrally cleared to be tradedon exchanges or an equivalent transparentplatform, as is now the case generally withstocks and futures contracts.

--Ensure that adequate reserves in the form ofcapital or margin are held against all trades thatare not centrally cleared.

--Require the margin or collateral backingderivatives positions to be held either insegregated accounts or by third parties (such as acentral clearinghouse) so that these funds cannotbe co-mingled with other assets of dealers.

--For derivatives that are both centrally clearedand traded on exchanges, regulators should

ensure that the transaction prices and volumes ofderivatives transactions are posted promptly onthe equivalent of a ticker (post-tradetransparency), while also ensuring that the pricesat which buyers are willing to trade (the bids)and sellers willing to sell (the asks) are madepublic so that all parties, not just the dealers,know the state of the market at any given time(pre-trade transparency). I believe that a priceticker, or something close to it, should be inplace even without central clearing and/orexchange trading.

2Clearing refers to all of activities that are involved inconfirming, monitoring and ensuring that sufficient collateralor margin is provided (where it is required) until a trade isactually settled (monies exchanged between the buyer andthe seller). A central clearinghouse performs all theseactivities in one place, and acts as the legal go-between forthe buyer and the seller. The distinction between bilateraland central clearing is discussed more fully in the body ofthis essay.

In short, the ultimate objective should be to

make current OTC derivatives look and trade

like futures contracts, which are standardized

instruments requiring (like OTC derivatives)

future performance by both parties but arecleared centrally and traded on exchanges.

Unlike futures contracts, however, which are tied

to specific exchanges and their wholly owned

clearinghouses, the presumptive markets for both

the clearing and exchange trading of derivatives

should be competitive, with the same instrument

capable of being traded on different exchanges.

For those contracts that are not centrally

cleared, there must be sufficient reserve held

against them to ensure that if one party defaults,

the other party is not dragged down with it.

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Where We Are Now

e are far from this ideal world today. Mostderivatives are traded over the counter (noton organized exchanges or their electronic

equivalent) by a handful of dealer banks that

currently dominate these markets, and wherethere is only limited post-trade pricetransparency.3 To be sure, some limited progresstoward central clearing of CDS has been made inrecent months, with CDS contracts betweendealers now being cleared centrally primarilythrough one clearinghouse (ICE Trust) in whichthe dealers have a significant financial interest.Nonetheless, virtually all end-users CDScontracts with dealers still are settled bilaterally,despite the presence of another clearinghouse(CME) specifically trying to enter this business.Progress has been made toward central clearing

of interest rate swaps only between dealers onone major clearinghouse (LCH Clearnet, inwhich dealers also have a significant financialinterest). There is still essentially no buy-side(institutional investor) central clearing or tradingof CDS on exchanges or electronic platforms inthe United States, although there is electronictrading of CDS in Europe, but so far exclusivelybetween dealers.

Clearinghouses step into the middle ofderivatives trades, becoming the buyer to everyseller, and the seller to every buyer. By endingthe bilateral relationships between the two

counterparties to derivative contracts, centralclearinghouses reduce the risk that the failure ofany one party could trigger domino-effect losseson other counterparties. Clearinghouses protectthemselves against their own failure, meanwhile,through several measures. They require bothparties to the trade (currently the dealers, butultimately also end-users who may eventuallyparticipate) to post initial cash margin andcontinuously update it through variationmargin that is tied to the market value of thederivative. As backup, clearinghouses requiremembers to contribute capital to a reserve fund.

As further backup, clearinghouses assess theirmembers for any losses the first two mechanismsmight fail to cover.

Central clearing is important but not sufficient tobring fundamental reform to derivatives markets.To the maximum extent possible, derivatives

3The same logic supporting exchange trading ofstandardized derivatives applies to the trading of U.S.government and corporate bonds, which up to now has beenconducted over the counter. But that is not my subject here.

should be traded on exchanges (or theirequivalents, such as on electronic platforms), justlike futures contracts and stocks. This wouldhave two benefits. First, exchange trading would

further reduce systemic risk by exposing to themarket in real time the volumes and prices ofderivatives transactions, thus facilitating moreaccurate and timely margining by parties toderivatives contracts. In addition, exchangetrading, coupled with true pre-trade and post-trade transparency, would narrow tradingspreads (the difference between offers to buyand sell), and thus benefit the ultimate end-usersof derivatives or investors. Indeed, it is possibleif not likely that with more price transparencyand exchange trading, many end-users would beable and would want to access trading platforms

directly, without the need to use dealers asintermediaries, just as has happened with stocktrading on electronic platforms. For this reason,notwithstanding the concern of some end-usersthat margin requirements on their derivativestransactions will make them more expensive, Iconclude that it is in the end-users interest, bothin the short and long runs, for all standardizedderivatives to be centrally cleared and traded onexchanges.

This is not to deny the benefits of customizedderivatives, which enable parties to refine theirhedges to the very specific financial risks they

may face, but which because they are notfungible or standardized cannot practically besubject to central clearing or exchange trading.There should and always will be a role forcustomized derivatives, especially for interestrate and foreign currency swaps which often aretied to very specific financial instruments.Indeed, U.S. hedge accounting rules encouragethe use of customized instruments that match thederivative closely to specific underlying risks towhich end-users of derivatives are exposed.Parties to these customized trades haveincentives to require their counterparties to post

margin or collateral to ensure payment.Nonetheless, because some users or dealers ofcustomized contracts can be so interconnectedwith other parties that their failure may poserisks to the health of the financial system as awhole, regulators must ensure that capital andmargins for the parties to these customizedcontracts take proper account of the potentialexternalities of the failure of certaincounterparties.

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Proposals for Change

n May 2009, the Obama Administration madecentral clearing and exchange trading ofstandardized derivatives a key part of its

comprehensive financial reform package. In

addition, the Administration proposed thatregulators have the authority to set capital andmargin requirements for non-standardderivatives for the reason just stated. TheAdministrations specific proposals are largelyincorporated in the comprehensive financialreform bill passed by the House ofRepresentatives in December, 2009. The Senatebill introduced by Banking Committee ChairmanSenator Dodd in November 2009 and in revisedform in mid-March 2010 has similar elements.

At this writing, however, several things are

unclear. One uncertainty is the extent to whichend-users of derivatives (institutionalinvestors, state and local governmental entities,and many companies that use these instrumentsto hedge) and active market participants who willseek to portray themselves as end-users will beexempted from the clearing and exchangetrading requirements or inducements. For

reasons I spell out below, efforts to carve out abroad end-user exemption should be resistedand any exemptions should be narrowly drawn.Regulators also should be able to counter

subsequent efforts by derivatives traders toexploit any initial exemptions. In this regard, it isnoteworthy that the Dodd bill has narrowerexemptions than the House bill.

It is also unclear how much authority regulatorseventually will be given over all features of thederivatives market. More broadly, while the oddsof passage of a major comprehensive bill seem tohave gone up since the enactment of health carereform, passage of a financial reform bill thisyear is still not a sure thing. In any event, even ifa bill is enacted, a myriad of details still must be

developed by the primary regulators that arelikely to be charged with overseeing derivativesmarkets, the Commodity Futures TradingCommission (CFTC) and the Securities andExchange Commission (SEC). This regulatoryprocess is likely to take up to a year followingthe passage of any reform bill.

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Resisting Change: The Derivatives Dealers Club

espite the apparent consensus among manyexperts about how to fix derivatives markets by driving standardized derivatives to be

centrally cleared, if possible traded on

exchanges, in a far more transparent manner, andrealigning capital and margin requirements toensure appropriate risk reserves there is one setof parties that is and has reason to be quitecontent with the status quo: the major dealerswho now negotiate derivatives transactions.From the limited publicly available data (and it islimited precisely because the markets here are soopaque), the derivatives-related revenuesgenerated by the major dealer banks aresubstantial, in the range of $30 billion annually.Publicly available data do not indicate how theserevenues translate into profits, but it seems safe

to assume that dealers derivatives trading profitsare substantial. As I will show later, the dealersdominance and thus significant profits earned inthese markets is largely a product of the way thatderivatives trading has so far been structured asthe outcome of dealer-to-dealer negotiationsover the counter with very little pricetransparency. Where central clearing hasoccurred, meanwhile, it has been largelyrestricted to the inter-dealer market, rather thanto the trades involving end-users or buy-sidefinancial institutions, where the dealers are nowalways on one side of the trade and have

incentives to keep it that way.

Separately, the dealers reportedly have a majorfinancial stake in Markit, the only company thathas direct and broad based access to CDStransactions data, and thus controls the extent towhich those data are disseminated. In fact, asdescribed below, the data that Markit doesrelease are very limited and fall far short of thekind of information that now exists on stock andfutures exchanges: publicly available bids andasks (pre-trade transparency), as well as virtuallyinstantaneous reporting of actual trades (post-trade transparency). The dealers financial

involvement in Markit reduces incentives forthem to support more transparency or to maketheir data (or Markits) available to other dataservices. Likewise, dealers exert influence overthe Depository Trade and Clearing Corporation(DTCC), the data repository for derivatives.DTCC should have the ability to collect anddisseminate derivatives transactions prices, butgiven its joint data-related venture with Markit

(MarkitSERV), and likely dealer control of thegovernance of these facilities, neither party hasan incentive to expand access to more completeand timely derivatives pricing information to the

market that would compete directly with thelimited data that Markit now makes availableonly to its subscribers.

In theory, the derivatives reform legislation nowbeing considered by Congress, if enacted, isdesigned to overcome dealer resistance tomeaningful reform. In principle, if the law saysthat standardized derivatives must be centrallycleared and traded on exchanges or theirequivalents, then what can dealers still do tofrustrate constructive change? Unfortunately, theanswer is: too much. Although dealers (and

others) have a point that inducements for centralclearing and trading (in the form of lower capitalcharges on centrally cleared and tradedderivatives and higher charges on non-clearedtrades) are preferable to mandates, the dealersand certain end-users of derivatives still may beable to persuade Congress to exempt too manyparties to derivatives trades from theserequirements or inducements, which wouldenable the dealers to continue their middlemanrole in the markets. Further, even mandates mustbe applied to actual trading by regulators, anddealers have incentives to slow the application of

those mandates to their business and to narrowtheir scope. The more the one entity that nowdominates inter-dealer trading and in which thedealers have a financial stake and appear to havea significant role in governing, ICE Trust, is ableto secure a monopoly on central clearing, thebetter able dealers will be to slow down bothcentral clearing and exchange trading. Putsimply, as long as ICE Trust has a monopoly inclearing, watch for the dealers to limit theexpansion of the products that are centrallycleared, and to create barriers to electronictrading and smaller dealers making competitivemarkets in cleared products.

Perhaps most important, the current legislationwould leave untouched, through their apparentsignificant ownership interests in Markit, thedealers current control over derivatives pricingdata. Pricing data is the oxygen that enablesfinancial markets to thrive. As long as these dataare controlled by the entities whose economicinterest is to slow constructive reform, then users

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of derivatives will continue to trade with lessinformation than is now routinely available toparticipants in markets for stocks and futures,especially as long as many derivatives can bekept off exchanges.

For all these reasons, the dealers are thus likelyto resist or drag their feet implementing changesthat would reduce systemic risk in the financialsystem as a whole but that could significantlyreduce the dealers revenues and related profitsfrom the current arrangement or that make theseflows more volatile. This is so despite theapparent formal commitments of the dealers tothe Federal Reserve Bank of New York toaccelerate the central clearing of eligiblederivatives, an elastic term primarily determinedby central clearinghouses. In the case of CDS,however, central clearing is so far dominated bythe one entity (ICE Trust) in which the dealers

have a significant financial stake. ICE Trust thushas little incentive to expand central clearing toderivatives contracts where a non-dealer is on theother side of the trade.

Readers neednt take my word for the skepticismexpressed here about the intentions ormotivations of the major dealers. Consider theanswer that current CFTC Chairman GaryGensler reportedly gave at a meeting in Januaryto an assemblage of bankers (mostly at the majordealer-banks) who asked the Chairman what hesaw as the biggest obstacles to derivativesreform. Gensler replied: You (meaning thebanker-dealers).4 To be sure, Chairman Genslersurely has his own motives for wanting reform,and people may have honest disagreements withhis policy views. But I believe that Gensler, whohas ample Wall Street experience of his own, isright on the mark in his assessment of where thedealers economic incentives and interests reallylie.

4Quoted in Ian Katz and Robert Schmidt, Gensler TurnsBack on Wall Street to Push Derivatives Overhaul,Bloomberg, February 12, 2010.


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Summary of Recommendations

o what can be done to overcome dealersresistance to constructive change? I advancea number of recommendations in the

concluding section of the essay, which I now

briefly summarize.

As a threshold matter, I argue that the currentregulators of derivatives markets yes, there isregulatory authority over these instruments eventhough Congress enacted certain regulatoryexemptions in 2000 have authority to take anumber of measures to ensure meaningfulreform, regardless of whether Congress enactssome version of the House or the Dodd bills.These agencies include the Commodities FuturesTrading Commission (CFTC), the Securities andExchange Commission (SEC), the Federal

Reserve Bank of New York (which already hasbeen active in this area), and potentially theAntitrust Division of the Department of Justice(which already is currently investigating Markitfor possible antitrust abuses). I want to be clear:statutory reform remains essential, and generallyspeaking regulators should wait until Congressfinishes its work on reform legislation. Butregulators are not powerless even under existinglaw and should take action if legislative reformfails this year, and possibly in some cases evenbefore.

First, as already hinted at, it is preferable toinduce rather than require central clearing andexchange trading through the judicious use ofcapital charges on trades that are not centrallycleared or exchange traded. The Federal Reservehas this ability now and should use it, initially byseeking agreement on just this aspect of a newcapital-based regulatory system for banks, fromits counterparts in the United Kingdom and theEuropean Union to prevent dealers fromshopping their trades to the most advantageous(least onerous) jurisdiction. If a commonderivatives capital rule cannot be quickly agreedupon, the Fed should move on its own.

Establishing the appropriate risk-based capital-based incentives will more quickly produce theright market-based solutions that align with thebroader social interest in reducing systemic riskfrom derivatives activities.

Second, once exchange trading of at least someCDS instruments gets underway, regulatorscould require the exchanges to implement both

pre-trade and post-trade transparency that is, topost bids and asks, as well as actual transactionsprices in as close to real time as possible. Evennow, however, before CDS are actively traded,

actual prices should be reported much morequickly than is now the case by centralclearinghouses and/or trade repositories. It ispossible, if not likely, that the SEC and theCFTC has sufficient authority to produce thisresult now even without legislative reform.

Third, regulators could compel governancereform of ICE Trust, the one U.S.-basedderivatives clearinghouse, where dealers have asignificant financial stake. Such reform isprobably best pursued by the SEC and theCFTC. It should entail a requirement that all

directors be independent of dealers. Congresswould help by giving regulators the soleauthority to set capital requirements and otherrules for membership in all derivativesclearinghouses.

Fourth, regulators can and should impose a seriesof non-discrimination requirements.Clearinghouses (especially those like ICE Trustwith a significant dealer financial stake) shouldbe required to deal fairly and equally with non-stakeholder dealers, non-dealers (with sufficientfinancial strength, defined by the regulators, tojoin the clearinghouses), and exchanges. Dealers,derivatives clearinghouses (ICE Trust andCME), and data repositories (DTCC) should berequired to make their pricing data available onequal terms to all vendors or pricing services.Such requirements (which may require thesuccessful intervention of the JusticeDepartment) would bring derivatives markets inline with securities markets. With respect toclearinghouses in particular, one desirableapproach would be to establish multiple tiers ofmembership or its equivalent: tying theminimum capital threshold to the open positionsof any member, perhaps above a certain size. If

financial assessments are necessary becausemargins are not sufficient to cover the costs offailure of a large member, those assessmentsshould be made proportional to a membersrequired contribution to the clearinghousesreserve fund.

Fifth, if the antitrust authorities find broadabuses by dealers and/or entities they control or

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in which they have a significant financial interest(ICE Trust, Markit, DTCC/MarkitSERV, andpotentially other organizations) they could limitdealers to a minority, non-controlling ownershipposition in each of these entities, or even forcethe dealers to divest all of their currentownership interests, and take steps to ensure thatthese facilities are governed in the broader publicinterest. Such steps would ensure that the keyinfrastructure of the derivatives market theinstitutions engaged in clearing, exchangetrading and transactions reporting (pre and post)

is competitively structured. This outcomewould reinforce, and even conceivablysubstitute, for some of the above measures that,for any number of reasons, may not beimplemented.

Taken together, the foregoing package ofmeaningful reforms to the derivatives marketwould make it far safer and more efficient, withlower bid-ask spreads, which would benefit end-users and the economy as a whole.


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A Cliffs Notes Guide to Derivatives

efore turning to the main arguments of theessay and especially solutions to theproblems in derivatives markets, some brief

background on derivatives, the infrastructure for

trading them, and their benefits and risks, isuseful to have. For more detail on these subjects,readers should consult an excellent recent surveyon these topics in The Economist.5

Derivatives come in many different types, butthey have one thing in common: in each casetheir value is derived from some otherunderlying or reference security orcommodity. Futures contracts require thepurchaser to buy (take delivery on) or sell(deliver) some item at a fixed price at somefuture date. An option gives the buyer the right

(but not the obligation) to do the same.

Both futures and options are traded on organizedexchanges. Exchanges match orders to buy andsell, rather than having dealers in between whonegotiate the transactions prices over thecounter (OTC) (although exchanges may havemarket-makers or their functional equivalentsto provide liquidity by taking the other side oftrades when there is insufficient order flow frommarket participants).

All exchanges arrange for trades to be cleared

(essentially validated) by a central clearinghousewhich stands between buyers and sellers so thatthey dont deal directly with each other, but withthe clearinghouse in the middle. If parties havemultiple offsetting trades, the clearinghouse isable to net the different positions against eachother and thus bill or pay only these net amounts.This reduces the overall gross exposure of theclearinghouse relative to the total of the bilateralgross exposures of the parties to each other in theabsence of a central clearinghouse. In this way,central clearing is likely to reduce the risks to thefinancial system from the failure of any of theparties to these trades.

5 Over the Counter, Out of Sight, The Economist,November 12, 2009 at

www.economist/research/articlesBySubject/PrinterFriendly.cfm?story_id=14843.

Many futures exchanges own their ownclearinghouses, which effectively limits thetrading of particular contracts whether forcommodities, securities or baskets of securities

(indexes) only to those that are cleared by theclearinghouses owned by the exchange. Wherethis is the case, customers who want to buy orsell a particular futures contract must pick theexchange (and the clearinghouse) on whichtrading of that contract takes place. In principle,U.S. and foreign futures markets do competewith each other, offering customers some choice.But as a practical matter, futures products tendnot to be fungible across markets andclearinghouses.

In contrast, stocks of individual companies are

traded on multiple exchanges in the UnitedStates, but are cleared through only a singleclearinghouse, the Depository Trust ClearingCorporation (DTCC).6 Each regional stockexchange used to have its own clearinghouse, butover time the clearinghouses were merged into asingle one, DTCC. Similarly, all options arecleared through a single regulated utility, theOptions Clearing Corporation, but optionsthemselves are traded on multiple exchanges.Competition among these exchanges has notalways been healthy, requiring an antitrustinvestigation and settlement by the Department

of Justice in 2000 to bring about change. Justicehas since noted that the benefits of competition [among options exchanges] havebeen substantial and lasting.7 Drawing on thisexperience (and other evidence), Justice hasrecommended to the Treasury Department that asimilar approach be taken in futures markets namely, that futures exchanges not be allowed toown clearinghouses, so that all futuresclearinghouses (or any single one, if the futuresclearing market reduces to one) will haveincentives to deal with multiple exchanges (as instocks and options).

6 The SEC has been directed by the Congress (as part ofSecurities Act Amendments enacted in 1975) to facilitatecompetition between exchanges through national marketsystem rules for clearance and settlement.7 Comments of The United States Department of Justicebefore the Department of the Treasury, TREAS-DO-2007-0018, at 17.

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Swaps

n recent decades, a whole new genre ofderivatives swaps -- has been designedprimarily by financial institutions initially to

meet the customized needs for hedging by a wide

range of both financial and non-financialcorporations, and subsequently to serve, in manycases, as highly liquid and efficient means oftransferring risks.

By far the most important of the swaparrangements, by notional volume, are interest-rate swaps, in which the parties swap differentkinds of payment streams, such as those tied to afixed interest rate for those tied to a rate thatvaries, or vice versa. At year end 2008, thenotional total of interest rate swaps exceeded$400 trillion, but the total amounts at risk the

annual payments that are actually exchanged are far lower, less than 5 percent of the totalnotional amounts to which the payments refer.Of less importance are currency swaps (in whichcase the parties exchange payment streamsdenominated in different currencies), or swapstied to the price of various commodities,especially oil, or to individual stocks or groupsof them (represented by an index).

Perhaps the most controversial swaps are creditdefault swaps (CDS), because these contractswere at the heart of AIGs financial difficulties

(and also played significant roles in the failure ofLehman Brothers and the rescue arranged forBear Stearns). In a CDS, the buyer makes regularpayments over some fixed period (typically fiveyears but as short as a single year and as long asten years) to the seller, who pays the notionalamount of the CDS if the issuer of the referencedobligation (such as a bond or a loan) defaults.CDS contracts are sold on the debt of singlecompanies or countries, on specific issues ofmortgage securities, or indices of theseinstruments. Although most of the adversepublicity and commentary about CDSarrangements refers to the insurance they

provided for mortgage-related securities, in factonly about 1% of all CDS cover theseinstruments. Over 90% of CDS are written tocover corporate defaults (or corporate indices).8

8Based on data reported by the Depository Trust & ClearingCorporation.

There are basically two types of buyers or usersof swaps: those who want to hedge againstcertain financial risks, and those who want tospeculate or bet on them. Both types of users

depend on the other. Hedgers benefit fromhaving speculators in the market because theydeepen the pool of buyers and sellers. The sameis true for speculators who benefit from thepresence of hedgers in the market.

Even most critics of swaps concede theirusefulness for hedging. For example, each of theparties to an interest rate swap want somethingthat the other has either a fixed or variablepayment on an underlying loan or bond -- butwant to get it without selling the underlyinginstrument. Currency and other commodities

swaps may have a different maturity and otherfeatures that are not available with a currentstandardized future or option. There are multiplehedgers who purchase CDS: suppliers, customersand lenders, each of whom may be worried aboutthe future ability of debtor to honor itscommitments.9 According to a 2009 survey bythe International Swaps and DerivativesAssociation, 94% of the 500 largest globalcompanies use derivatives; over 70% of theU.S.-based non-bank corporations use interestrate or currency derivatives; and of U.S.-basedbanking companies, all use interest rate and

currency swaps, while 88% use CDS.

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9 Dean Baker has argued that because lenders are in a betterposition to assess the risk of borrowers than sellers of CDS,the CDS backing loans represent a pointless transfer of riskthat benefits no one but the CDS sellers. See Dean Baker,Financial Innovation: What Is It Good For (II)? CreditDefault Swaps, March 11, 2010 available atwww.tpcafe.talkingpointsmemo.com. Baker may be right insome cases, but CDS sellers can also have specializedindustry expertise that put them in a better position to assessrisk than even the originating lender (admittedly that was nottrue for the mortgage industry, but as noted, mortgage-relatedCDS account for a tiny fraction of the overall CDS market).

In any event, at least as of 2005, only 23 U.S. bank holdingcompanies had any CDS positions, and on average, theyhedged only 2 percent of their loans. See Bernadette Minton,Rene M. Stulz, and Rohan Williamson, How Much DoBanks Use Credit Derivatives to Hedge Loans? Journal ofFinancial Services Research, 35(10, 2009, pp. 1-31.Furthermore, Bakers argument has even less force whenapplied to other CDS purchasers, such as suppliers orcustomers who may not have any better information, andindeed possibly less,than sellers of CDS who specialize inthat activity.10 Data available on the ISDA website. www.isda.com.

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Speculators in CDS (and other derivatives) those who do not have economic interests in thereferenced obligation have been the maintargets of criticism, unjustifiably so in my view. Ispell out why in a later section of this essay.

In understanding how swaps markets actuallywork, it can be useful to distinguish betweencertain end-users, buy side participants, anddealers. End-users consist of parties whopurchase or sell derivatives primarily for hedgingpurposes, notably private companies and stateand local governmental entities. Buy-sideparticipants include institutional investors(insurance companies and pension funds) andhedge funds, both to hedge and to speculate, justas retail and institutional investors buy stocks orbonds.

Buy-side participants and end-users (hereafter,

unless otherwise distinguished, I will refer toboth collectively as end-users) purchase or selltheir derivatives through dealers, with whomthey have a contractual relationship. In turn,dealers almost always lay off customerstrades by entering into contacts with otherdealers (whose clients take the oppositepositions). In the CDS market, for example, suchdealer-to-dealer transactions account for about80 percent of all positions, and most of these netout against each other. For example, as of June2009, the net exposures of dealers in CDStotaled $3 trillion, compared to a gross

notional total of $23 trillion in dealer-to-dealertransactions (and a notional total of $28 trillionfor all CDS).11 As I explain later, in a bilateralmarket, because all contracts requireperformance by counterparties over a longperiod, virtually all end-user trades are with bankdealers, generally the large ones perceived to betoo big to fail (TBTF).

The dealer-based arrangements in the OTCswaps market are analogous to the way stocksused to be traded on NASDAQ before 1997,through dealers who have inventories of the

stocks that they sell or buy, with prices setthrough the interaction of supply and demand inthe market. In contrast, stocks traded onNASDAQ today or NYSEuronext are bought

11 Darrell Duffie, The Failure Mechanics of Dealer Banks,Journal of Economic Perspectives, Winter 2010, pp. 51-72,at 58. This article provides a superb discussion of themechanics of dealer banks derivatives activities and thedangers they may pose to the banks and the rest of thefinancial system.

and sold through a continuous auction, with noneed for a dealer in between, with full pricetransparency, which is not the case in the OTCderivatives market. In many cases on bothexchanges, however, stock orders that matchor are placed at market are completedelectronically. In other cases, market makers ortheir functional equivalents provide liquidity bytaking the other side of trades when there are fewor no orders from market participants.

As I discuss later, a relatively small number ofdealers (all major banks or bankingorganizations) dominate the dealer-to-dealertrades of OTC derivatives. Historically, becausethese institutions are large and their credit wasdeemed to be good, dealers do not require eachother to post margin or collateral to ensurepayment. The dealers have many transactionswith each other, many of which are offsetting, so

they end up owing each other only the netamounts due. The 2008 financial crisis changedthis somewhat, and now a higher number ofdealer-to-dealer trades are cross-margined,though the margin levels are negotiated ratherthan set by any regulatory or objective standard.As a result, there is still uncertainty aboutwhether margins on dealer trades are sufficient.

Dealers historically have required theircustomers, or end-users of derivatives, to postinitial margin. But the dealers do notreciprocally post initial margin to customers.

Both parties typically exchange variationmargin (discussed in more detail soon),depending on the nature of the contract and itscurrent price. As discussed below, however, theinitial margin or collateral is not typicallysegregated in special accounts, and so the end-users must rely on the general financial health ofthe dealer to ensure payment. This reliance,obviously, failed when Lehman Brothers failed.

To add a bit of further complexity, certaincorporate end-users have been permitted bydealers not to post initial margin, while variation

margin also can be and has been waived wheredealers judge the corporate customers financialposition to be strong. When margin is waived,however, there may be significant amounts ofunfunded receivables that cannot be recovered ifeither party defaults. While in certain markets,such as CDS, corporate end-users represent arelatively small share of overall market exposure,in other markets, such as interest rate swaps,corporate end-users are relatively much more


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important. The implications of the marginwaivers for corporate end-users are loudlydebated. Some argue that corporate end-users didnot cause the 2008 financial crisis and thereforeshould not be obliged to fund an increase inreserves (through margins) backing the system.Others argue that through margin waivers,

corporate end-users have been free-riding onothers margins and that so long as they dontpost their fair share of margin, the dealer bankswill remain too interconnected to fail. Putdifferently, the waiver of margin for corporateend-users externalizes the risks that these partiesand their dealers pose to taxpayers.

Swaps (Primarily CDS) and Systemic Risk

s certain recent financial bailouts havehighlighted, the current CDS market exposesthe financial system to undue systemic risk if

one or more of the large and interconnectedparticipants in the market especially the dealers fails or runs into severe financial difficulty.Systemic risks also arise in the markets forinterest rate and currency swaps, but appear sofar to be less dangerous, even though these

swaps are substantially larger in total volumethan CDS, with current outstanding contracts ofabout $25 trillion in notional value, down from apre-crisis peak of over $60 trillion (most of thisreduction is due to compression trades whichshould effectively cancel redundant positions). Inan interest rate or currency swap, if one partydoesnt perform that is, provide the payments itowes the other party will do likewise. Therewill be some costs of replacing the failed swap,but these costs are likely to be much less,especially in a larger system-wide crisis, than thecosts from the failure of a seller of CDS

protection to pay off if required. In addition,central clearing of interest rate swaps, primarilythrough LCH Clearnet based in London, is muchmore extensive than for CDS, albeit only fortransactions among dealers.12

In a nutshell, the systemic risks in the CDSmarket arise out of the bilateral nature of thesecontracts, which call for future performance byboth parties. All derivatives entail some futureperformance, which distinguishes them fromtransactions in the cash market in which oneparty pays cash for a security or commodity and

then the deal is done. In contrast, with a futures

12 At close to year end 2009, approximately 35% of the totalamount of OTC interest-rate derivatives was being centrallycleared, though again only for dealer-to-dealer transactions.One study indicates that this figure could be raised toapproximately 63% if all other eligible interest swaps weretreated similarly. Darrell Duffie, Ada Li and Theo Lubke,Policy Perspectives on OTC Derivatives MarketInfrastructure, Federal Reserve Bank of New York StaffReport No. 424, January 2010.

contract, the party that buys or sells it must dosomething before the maturity date, which leavesthe exchange or clearinghouse to which it isobligated exposed to the possibility of non-performance. To protect itself against that risk,futures exchanges require parties doing businesswith them to post initial margin (some smallfraction of the market value of the futurescontract) at the time of purchase or sale and then

to update that amount (typically daily) withvariation margin (or maintenance margin) ifthe value of the contract falls, exposing theexchange (and its clearinghouse) to greater risk.

In principle, dealers of CDS protection requirecounterparties to do something similar: to postcollateral in some form in order to providecomfort that the parties can make good on theircommitments. In some but not all cases, thecollateral is placed in a segregated account sothat it is not comingled with other funds of theCDS seller. In addition, the typical CDS contract

requires the seller to post additional collateral (ormargin) in the event of some event, such as adowngrade of the sellers credit rating, thatreduces the likelihood that the seller could honorits commitment (the credit rating of the sellerbecomes especially important where thecollateral is not segregated, since in that eventthe buyer of protection must look only to thegeneral creditworthiness of the seller). Frompublic accounts of the AIG affair, somepurchasers of the roughly $400 billion in CDScontracts it sold did not have collateral insegregated accounts, which meant that their

insurance from AIG could have been worthlesshad the company become insolvent. Further, theproximate cause of AIGs downfall was thedowngrade of its credit rating after LehmanBrothers failed, which triggered additionalcollateral obligations AIG could not meet.

The subsequent bailout of AIG highlighted thedangers of the bilateral nature of the CDS market

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as it has developed, but this event is not the onlyfactor that underscores these risks:

--According to an ISDA survey in 2007, only 63percent of OTC derivatives contracts in generalrequired collateral (although this figure was upfrom 30 percent in 2003).13 In contrast, allfutures contracts require margin or collateral.

--As noted, the collateral required by dealers isnot always segregated in special accountsavailable in the event the parties cannot honortheir obligations under the swap. Margin postedby buy-side participants, meanwhile, is typicallymelded with the dealers other working capitaland used to support its general activities. Indeed,large dealers may have the leverage to extractconsiderable margin from some end-users, and inany event profit from the spread between whatthe dealers pay customers on any margin they

post and earnings the dealers generate wheninvesting those funds in higher yieldinginstruments.14 In other cases, as already noted,with some larger end-users, dealers may notinsist on margin. The margin arrangements in theOTC derivatives market contrast with the typicalfutures contract which requires margin to besegregated.

--The collateral in CDS arrangements also hasnot always been in cash, and in these cases is notalways easily sold by the collateral holder even ifit is segregated. Since the financial crisis,

however, over 80% of the collateral for OTCderivatives has been in cash.15 Futures marginsare always in cash or cash equivalents (such asshort-term Treasury bonds).

--Under current bilateral relationships, if a buy-side participant wants to transfer its position to adifferent counterparty perhaps because it haslost some faith in the ability of the originalcounterparty to pay off or to close out aposition, the transfer or closeout requires theoriginal dealer to consent, for which it typicallycharges an unwind fee.16 If derivatives

contracts were cleared centrally, theclearinghouse could effect the transfer to a

13 Cited in Stulz, at 81.14 Michael J. Moore and Christine Harper, Goldman SachsDemands Derivatives Collateral It Wont Dish Out,Bloomberg, March 15, 2010.15 International Swaps and Derivatives Association, ISDAMargin Survey (ISDA Technical Document, 2009).16 In addition, when a transfer is made, any net gains or losseson the instrument need to be settled at that point.

willing alternative clearing member through abook entry without charging an unwind fee, orcould simply close out the transaction byentering into an offsetting trade that would netout all or part of the first one. Instead, to avoidthe unwind fee in the bilateral market,participants enter into offsetting contracts withdifferent counterparties. While this neutralizestheir market exposure, it also doubles overallcounterparty exposure in the market.

--When asking for collateral, firms and theircounter-parties take account (understandably)only of the risks that the parties to the individualswap may not be able to pay them. Buyers do notfactor in the externalities of either partiesinability to honor their contracts, namely thepotential cascade of losses that one partysdefault could impose directly on other parties, aswell as the potential indirect impacts of these

losses on the counterparties of other buyers. Itshould also be noted that there is no datacollection or monitoring system in place foridentifying or quantifying theseinterrelationships (an omission that, in principle,could be corrected if Congress creates asystemic risk monitor, or failing that, if thecurrent Presidents Working Group on FinancialMarkets establishes such a system).

--Under the master swap agreement provisionsof CDS instruments set by International Swapsand Derivatives Association (ISDA) an entity I

discuss in more detail below if two parties to aCDS have offsetting obligations to each otherrelating to CDS or other swap arrangements,these are netted so that the obligor is requiredonly to pay the net amount due (rather than haveeach party pay its gross obligation to theother). But these netting arrangements are onlybilateral. If party A owes party B as a result of aCDS, but A is hedged and is in a position tocollect from C, all of these bilateralcommitments must be honored. If instead all ofthe parties had entered into their CDS contractswith a central clearinghouse (also to be discussed

shortly), C would owe B directly because Asoffsetting (or hedged) positions would be nettedout.

Beyond these well-known differences betweenfutures contracts that are centrally cleared andtraded on exchanges, on the one hand, and thelargely bilateral nature of the OTC market inCDS, on the other, there are also markeddifferences in transparency in the two markets


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that have important implications both forsystemic risk and market efficiency (which areclosely interrelated).

Unlike futures exchanges or stock markets,which provide continuous information abouttransactions prices and volumes, for CDScontracts there is only one source of after-the-fact pricing information and even then the dataare not actual transactions data. What limitedCDS price and volume data that now exist arepublished at the end of each trading day byMarkit, which collects and compiles thetransactions data reported to it by dealers at theend of each day (or frequently earlier, becausenot all trading desks make the cut-off for all theirtransactions and thus report stale prices from theday before). Markit then reports back essentiallyan average price for those transactions. Whenthere is no objective central price (like those

provided on a stock ticker), dealer desks are notrequired to mark their books to reflect actualtransactions prices. Instead, they mark accordingto what they deem their positions to be worth.Markits pricing service providing an effectiveaverage of such dealer marks and some actual,but late, transactions prices by definitioncannot be indicative of the latest market valuesof specific CDS contracts. At bottom, neitherMarkit nor anyone else (because they lack access

to the dealer price data) provides purely actual

transactions prices in anything close to a timely

manner.

Furthermore, there is no pre-trade transparencywith OTC derivatives. End-users do not knowthe equivalent of the bid and ask prices, againespecially for CDS, but must rely entirely on theprice at which dealers claim to be able topurchase or sell a particular instrument. Intheory, end-users can shop around at the fivemajor dealers, but in practice and as a generalrule, dealers will not, even for standardizedderivatives, provide a firm quote, but instead willjust give an indicative or conditional price: ifyou give me the business, I will try to get you

such and such a price. Even though dealers sendout runs to their customers -- indicative bidsand offers on a range of instruments -- the actualprice the dealer will transact with is entirelysubject to bilateral negotiation, on the phone orin some electronic email-like exchange. The

dealer is free to change the price until themoment the trade is mutually closed.

This process is clearly inefficient, especially inthe CDS market where $2.5-5 trillion ofcontracts (notional amounts) are traded everymonth. As a result, end-users are totallydependent on their dealers often a particulardealer with whom they regularly conductbusiness to get the best price they can for theircustomers. End-users and buy-side participantscannot know whether that price is the best one,since there is no pre or post trade transparency:they dont know what other parties are willing topay or to sell at, nor do they have comparablereal-time price data against which to compare theprice of their particular trade.

Such an opaque environment is an ideal one forthe few dealers who currently dominate the

derivatives markets. The less their customersknow, the wider the spreads or markups they canearn. This state of affairs not only fails to protectthe interests of investors or end-users, but it hassystemic consequences. Where collateral ormargin is required, systemic risks are reducedthe more frequently and more accurately thoseamounts are calculated. Daily marks based onend-of-day average prices (not all of themtransactions-based) subject all parties toderivatives transactions and the financialsystem as a whole to greater risks than if allparties had access to true bid and ask prices

before trades are conducted, and to actualtransaction prices on a close to real time basisafter trades are completed.

Though central clearing is likely to reducesystemic risk for reasons already given, evenfurther reduction of risk would be brought aboutby improving the limited price transparency thatnow exists so as to further improve the accuracyand timeliness of market-based data to markderivatives positions. At a minimum suchimprovement would be accomplished bypublication ofactual transactions data at the end

of each day, or even more frequently. Ideally,however, the markets would be better served andsystemic risks reduced if CDS and other currentOTC derivatives began, as a matter of course, tobe traded on exchanges, and firm pre-trade bidsand asks were publicly available.


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Recent Derivatives Market Reform Initiatives: Public andPrivate

ortunately, at least in some quarters, the needfor major derivatives market reform is well

recognized. This is reflected in theAdministrations reform proposals and in the

Congress. The New York Fed also has takenimportant steps to encourage reform, which has

had some positive effects. These initiatives arereviewed in turn.

Administration and Congressional Reform Proposals

n May 2009, the Obama Administrationproposed, as part of its comprehensivefinancial reform legislation, to reduce systemic

risks and to enhance transparency in derivativesmarkets through a series of provisions aimed atdriving all standardized derivatives to centralclearinghouses and exchanges, requiring marginto be placed in segregated accounts, and all

trades to be recorded in trade registries. InDecember, 2009, the House of Representativesresponded by passing a comprehensive reformbill that clearly was influenced by theAdministrations proposals, but with broadexemptions for trades where one of the parties isnot a dealer.

In particular, the House bill would require thecentral clearing of all trades between dealersinvolving standardized OTC derivatives. Whatconstitutes a standardized instrument would bedetermined by regulators (the SEC in charge of

derivatives tied to securities or narrow indices,with the CFTC overseeing all other derivatives),though the bill would establish a presumptionthat all derivatives of any class that aclearinghouse accepts for clearing would have tobe cleared. Presumably, this would mean that ifone clearinghouse accepted a 5-year CDS on,say, the bonds of ATT, all such CDS would haveto be centrally cleared. In principle, however, itwould appear under the House bill that regulatorscould be more aggressive in requiring centralclearing if they wished.

The House bill also would require allstandardized derivatives that are centrally clearedto be traded on an exchange, or its equivalent, aSwaps Execution Facility (SEF).17 The bill doesnot clearly define an SEF and this issue is stillbeing debated in Congress. It is possible that avoice brokerage facility would qualify, which in

17The Dodd bill refers to these entities as Alternative SwapsExecution Facilities.

my view would be a mistake, because it wouldnot materially differ from the typical OTCarrangements now. In defining the term,Congress should try to limit or analogize the SEFto the Electronic Communications Networks(ECNs) that have electronically matched the buyand sell orders for stocks since they were createdin the mid-1990s. It is noteworthy that ECNs

came into their own after the SEC issued orderhandling rules in 1997 that required brokers topost their customers bids and asks for the publicto see, following an investigation of the dealersin this dealer-market (very much analogous tothe current OTC derivatives market, but in thecase of CDS with far fewer dealers) for fixingthe bid-ask spreads.18 The SEC also greatlyfacilitated the growth of ECNs through itsRegulation ATS (Alternative Trading Systems)that permitted ECNs to operate like exchangesbut register as broker-dealers with few additionalrequirements. Once bid and ask information was

transparent, trades on matching orders could becompleted electronically.

The House bill also would charge derivativesregulators with additional duties. Normally,clearinghouses themselves set margins, but theHouse bill would enable regulators to set capitaland margin requirements for parties tocustomized OTC derivatives contracts that arenot suitable, by reason of their heterogeneity, forcentral clearing or exchange trading. Theseprovisions are aimed at preventing a future AIG,whose failure was due largely to its inability to

meet collateral calls on its customized CDS.

19

Atthe same time, the House bill would not require

18 Specifically, the SECs Limit Order Display Rule requiresmarket makers to display investors limit orders (thosespecifying a minimum acceptable sales price or maximumacceptable purchase price) that are priced better than themarket makers quote. The Commissions Quote Rulerequires market makers to publically display their bestquotes.19 Duffie, at 67.

F

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regulators to set margins on customizedderivatives where one of the parties is not adealer or major swap participant.

The major financial reform bill that the Senate isnow likely to take up the latest proposal bySenator Dodd, Chairman of the Senate BankingCommittee contains derivatives reformproposals that are similar to those in thelegislation already enacted in the House and tothose in an earlier bill proposed by the Chairmanin November 2009. Like the House bill,Chairman Dodds bill spells out a procedure forregulators and clearinghouses to determinewhich contracts should be cleared, and requiresboth the SEC and the CFTC to pre-approvecontracts before clearinghouses can clear them.In addition, Dodds bill requires clearinghousesor swap repositories to collect derivativestransactions data, though it is not clear how such

information will get to the market and howfrequently (these topics presumably would be thesubjects of further regulation).

So far, the most contentious aspect of either theDodd or the House bill relates to whatstandardized derivatives and/or whichparticipants or purposes would be exempt frommandatory clearing (and thus eventuallyexchange trading). Both bills would exemptderivatives in which one of the parties is not aswap dealer or a major swap participant, or ifthe transaction was entered into to hedge

financial risks. But the Dodd exemption looksnarrower, since it would apply only if aclearinghouse would not accept the parties to thetrade. A party thus would not get an exemptionsimply virtue of its size or hedging activities. Inaddition, the House bill would allow end-users ofderivatives to use non-cash collateral to meet anymargin requirements set by counterparties. Theexemptions are there to respond to complaints bymajor corporate end-users of derivatives, whohave asserted that mandatory clearing wouldrequire them to post more cash margin than isrequired of them now, increasing their costs of

using derivatives.

20

As a matter of substance, however, the corporateend-users are wrong. Current amounts of initialmargin (to the extent that dealers impose them

20 As discussed in the text earlier, in some cases, dealers donot require corporate end-users to post any margin at all(perhaps as a loss leader to gain other banking businessfrom them).

on end-users) are generally too low because theydo not take account of the externalities theirfailure may impose on the rest of the financialsystem (AIG being a classic case of this). At thesame time, however, end-users are paying higherimplicit fees to dealers in the form of largerbid-ask spreads -- for completing theirderivatives trades than would be the case ifstandardized derivatives were generally clearedand eventually traded on exchanges, with greaterprice transparency. In addition, greater pricetransparency, for reasons already given, wouldreduce systemic risk. Accordingly, end-users as agroup are likely to be better off, even with higherexplicit margins, if there were no exemptions atall.

In fact, the definitions of the exemptions in thebills of parties that are not swap dealers or majorswap participants could be exploited. Financial

regulation is fraught with many examples offinancial innovations that have successfullycircumvented the best-intended rules (as well asa number of socially counter-productive rules).21If the past is any guide, it is likely that teams ofattorneys at the dealer banks, some hedge funds,and other derivatives markets participants thatwant to avoid mandatory clearing are alreadybusy now trying to figure ways to fit within theexemptions in the current bills (perhaps throughinnovative definitions of exempt hedges ormajor swap participant). One way to preventthis regulatory gaming or arbitrage is to

allow the SEC and CFTC broad freedom tochange the definitions of both key terms swapdealers and major swap participants toprevent parties from circumventing the spirit ofthe laws, which are to drive more derivatives tocentral clearing and exchange trading (though,again, I would prefer that this be done throughcapital surcharges on non-cleared and non-tradedderivatives rather than through mandates). Otherways to mitigate gaming include: permitting end-user exemptions only if their total non-clearedexposures fall under some dollar threshold;allowing end-users to demand central clearing if

they want it; and requiring an end-user that is apublic company to have its decision to use non-cleared swaps reviewed by the audit committeeof the companys board.

21 This is one of the themes of my recent In Defense ofMuch, But Not All, Financial Innovation, BrookingsInstitute website, February, 2010, available at

http://www.brookings.edu/papers/2010/0217_financial_innovation_litan.aspx/


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Another concern with the current derivativesreform bills is that they would direct regulatorsto require central clearing and trading ofstandardized derivatives. There are severalproblems with mandates, and for reasons nowoutlined, I believe that at most they are betterframed as a last resort stick in the closet thatthe SEC/CFTC could use in the event otherapproaches to accelerating the clearing andtrading of standardized derivatives do not workout.

To begin, if the contracts required to be clearedturn on what standardized instruments theclearinghouses accept for clearing, then theregulators could be put at the mercy of thedealers who now control, or at least heavilyinfluence, the current dominant CDSclearinghouse, ICE Trust. As discussed shortly,despite commitments the dealers have made to

clear virtually all of their eligible contracts, thedealers lack incentives to maximize the volumeof such instruments subject to clearing.Presumably, the authority the bills would giveregulators to mandate clearing is designed tocorrect this problem. But this would putregulators in the position of second-guessing themarket, and either erring on the side of notpushing hard enough, or pushing too hard toforce clearing for instruments that really areinsufficiently standardized. In the latter event,regulators would put clearinghouses at greaterrisk, and thereby cause them to raise fees higher

than may be necessary.

All that being said, if faced with a choicebetween mandating clearing and exchangetrading, it would be better to do the former thanthe latter. A mandate that cleared derivatives betraded on an exchange or ASEF may becompelling outcomes that should not or cannotbe forced because the liquidity required to makeexchange trading might not be there. In addition,premature compulsion of trading of derivativescould reduce incentives for parties in the marketto develop new or customized derivatives that

eventually, once standardized, could move toexchanges. But if these products are still-bornthe market, by definition, would never benefitfrom them.22

None of this should negate the fact that there isconsiderable potential for exchange trading inderivatives. This is evident from the experience

22 Duffie, Li and Lubke at 10-11.

in Europe, where an estimated 75-80% of swapindices and 30-40% of the single-name swaps arealready traded electronically between dealersthrough various electronic trading platforms(BGC Partners, Blackbird Holdings, CompagnieFinanciere Tradition, Creditex, GFI Group, Icapand Tullet Prebon).23 Electronic trading ofderivatives in Europe is far more advanced thanin the United States most likely because CDStrading is spread among many more dealersoperating in different countries than is the casewith the highly concentrated market in theUnited States where a relative handful of dealerscan more tightly control the market through old-fashioned telephone conversations. Thisdisparity in electronic trading between Europeand the United States shows both that electronictrading of derivatives is possible and that it isimportant to implement the policy initiativesdescribed later for opening up the U.S. markets

to more clearing, exchange trading and pricetransparency.

The foregoing flaws with attempting to forceelectronic trading where it may not beappropriate explain why at least some academiceconomists who have studied this marketgenerally seem to prefer using capital charges asa way of harnessing market-like incentives toencourage the major dealer banks to use andclear standardized derivatives. Specifically, asubstantial capital penalty on non-standardizedpositions -- say, three to four times the capital

requirement against any position in standardizedinstruments would more properly recognize thesystemic risks posed by custom derivatives andin the process help overcome the incentivesdealers otherwise have to limit standardizationand hence clearing volume. The same is true fora capital penalty applied to cleared derivativesthat are not exchange traded (beginning withCDS). Incentives are more likely to lead tooutcomes that market participants actually wantthan potentially cumbersome and lengthyregulatory determinations.

But even though capital regulation should betterincent bank-dealers to clear their own derivativeswith each other, it may not crack dealersunwillingness to submit their trades with end-

23 Shane Kite, Manual Market: Swapping Electrons forPaper, in Credit Default Contracts Paper Plain: Default PactsResisting Electronics, FinReg21, at

http://www.finreg21.com/news/manual-market-swapping-

electrons-paper-credit-default-contracts-paper-plain-default-pacts-resis.


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users to central clearing. The latter would expandthe volume of derivatives that is centrally clearedand thereby make it easier for regulators (andend-users themselves) to demand that centrallycleared products also be exchange traded, anoutcome that is not in the dealers economicinterest. Moreover, any capital penalties adoptedby U.S. regulators unilaterally would simplydrive derivatives trading to other locations, mostlikely London or Frankfurt.

Since the financial crisis, bank regulatorsbelonging to the Basel Committee and the G-20have been working to refine the Basel II bankcapital standards, and specifically to include anadditional capital charge for non-cleared and/ornon-traded derivatives. The Basel II process is avery cumbersome one, however. It took theCommittee roughly a decade to agree on arevision of the Basel I standards, and by the time

the project was completed, the financial crisis of2007-08 had erupted. Despite the crisis or near-crisis atmosphere since those events, neither theCommittee nor the G-20 has yet produced a finalrevision of the Basel II rules. Indeed, if anythingthe United States and the European Unionremain considerably at odds over how to proceedwith financial reform generally, let alone withrespect to derivatives.24

Given this record, the United States would be farbetter off if our bank regulators worked with alimited number of counterparts specifically,

regulators in the United Kingdom and theEuropean Union who already are working onderivatives rules comparable to those now beingdiscussed in this country -- to reach agreementon a common set of capital surcharges for non-cleared and/or non-traded derivatives. This workshould speed ahead and hopefully reach a promptconclusion well before any final agreement onthe whole package of bank capital requirementsis agreed upon by the Basel Committee and/orthe G-20. Indeed, agreement by a core group ofcountries, led by the United States, on just thecapital regime for derivatives should help pave

the way for wider agreement on that issue withinthe larger bodies (just as agreement between theUnited Stated and the United Kingdom onessentially what became Basel I helped pave theway for the full Committee to establish thosefirst capital standards).

24 See Howard Schneider and David Cho, U.S., Europe atOdds Over Global Financial Reform, TheWashington Post, March 13, 2010, p. A1.

Indeed, the international agreement suggestedhere on capital requirements for cleared/non-cleared and traded/non-traded derivatives shouldbe pursued immediately and regardless of whathappens on the legislative front. If a satisfactorydeal is reached before Congress acts on thecomprehensive bill, then the mandates in thecurrent versions of the bills may still benecessary or helpful, but the market will movemuch more rapidly of its own accord to a saferstructure. If no capital deal is reached soon, thenmandates become an essential stick in thecloset that the SEC/CFTC must bring out andimpose to ensure that major dealers followthrough fully with their clearing commitmentsmade to the New York Fed discussed next, andthat further essential improvements to theclearing and trading of derivatives continue to bemade.


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Reform Initiatives of the New York Fed

t is not clear at this point whether Congresswill be able to agree on a comprehensivefinancial bill that is acceptable to the Obama

Administration, and what precise derivatives

market reform proposals such legislation wouldcontain. One particular federal agency, theFederal Reserve Bank of New York, has notbeen waiting for reform to be legislated,however, and for several years has been pushingthe major derivative dealer-banks on a number offronts.25

In 2005, for example, the New York Fedinitiated and accelerated efforts by the majordealer-banks to clear up extensive backlogs inthe recording and processing of derivativestrades. This led to the creation in 2006 of an

extensive derivatives trade data repository at theDTCC. The ratio of unconfirmed trades to newcredit derivatives transactions has fallen to lessthan one in 10, a marked decrease from pre-initiative levels (though the New York Fedshould continue to work with the dealers and theDTCC to entirely eliminate unconfirmed trades).

The New York Fed has also been encouragingthe dealers to clear eligible credit derivatives,or those sufficiently standardized to be suitablefor clearing. Thus, in September 2009, each ofthe major bank-dealers committed to clear at

least 95% of new eligible derivatives trades(calculated on a notional basis) by the beginningof October 2009, while collectively all dealerscommitted to clear 80% of all new eligibletransactions. The bank-dealers made roughlysimilar commitments with respect to the clearingof interest rate swaps.

25 For a more detailed summary, see Duffie Li and Lubke(2010).

The latest commitment by the major dealers isreflected in a letter they and selected buy-siderepresentatives sent to the President of the NewYork Fed on March 1, 2010. In that letter, the

signatories announced their commitment toincrease the range of products eligible forclearing and the proportion of their total productsthat are cleared; that they were exploring furtheropportunities for standardizing derivatives; andwere undertaking studies of ways to improvetransparency. The letter contained no newnumerical commitments and no specific productroll-outs, nor did it make any promises aboutmoving to the disclosure of actual transactionsprices, let alone firm offers to buy or sellderivatives.

While the New York Fed is to be commendedfor moving the dealers as far as they have, thedealers still have committed only to advance theclearing of eligible derivatives. Since thedealers control the committees that determinewhat is eligibleon the one clearinghouse thatdominates inter-dealer trading, there is noguarantee or incentive for the number of clearedproducts to expand rapidly. Further, since evenwith centralized clearing, all derivatives are stilltraded over the counter with dealers on at leastone side of every transaction the dealers stillvery much control the market, with very limited

price transparency. More to the point, asdiscussed shortly, only five dealers are on at leastone side of almost every OTC derivative trade.The impacts of this high degree of concentration,coupled with dealer control of the other keyelements of the derivatives market infrastructure,are critical subjects I also soon address.

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Recent Developments in Derivatives Clearing

ithin the last year, two entities haveengaged in the clearing of CDS in theUnited States. The overwhelmingly

dominant presence in the CDS clearing market is

ICE Trust, a limited purpose trust company thatis a subsidiary of ICE, a publicly-tradedmultinational company operating fiveclearinghouses in the United States, Europe andCanada. In March 2009, ICE acquired TheClearing Corporation, which had been one of theoldest clearinghouses in the world and wasowned by dealer banks. TCC developed thetechnology for clearing CDS (including thesetting of initial and variation margin), which isnow used by ICE Trust. According to publicreports, some number of bank-dealers(presumably those who controlled or were

heavily invested in TCC) share in 50% of theclearing revenues of ICE Trust. ICE Trust beganclearing CDS in North America in March,2009.26

ICE Trust was designed from the outsetessentially as a dealers only clearing bodysince it requires all clearing members to have atleast $5 billion in capital to join.27 This capitalthreshold, ostensibly justified for riskmanagement reasons, effectively keeps outsmaller dealers and brokers, and end-users whowould wish to clear directly. As just noted, the

dealers that formed the predecessor to ICE Trust,The Clearing Corporation, may have done so atbehest of the New York Fed, which wantedcentralized clearing of CDS and also hadsupervisory jurisdiction over its bankingmembers. Alternatively, the dealers looked atICE Trust as a way to stave off the threat of otherclearing platforms, such as CME or Eurex, thathave more open membership criteria.Nonetheless, because of the exclusive nature ofthe entity and the financial interest in itsperformance that dealers maintain, the maindealer-banks have used ICE Trust to clear all oftheir dealer-to-dealer transactions. As of late

March, 2010, ICE Trust had cleared over $4.4

26 Data and information in this section about ICE and itssubsidiary operations are drawn from the ICE website, unlessotherwise indicated.27 Again, according to the ICE website, there were 16clearing members in ICE Trust as of October, 2009. All werebanks, bank holding companies, or entities that belonged tobank holding companies.

trillion in notional CDS, of which only about1/10 ($460 billion) were buy-side trades.28

The sole remaining competitor to ICE Trust for

US CDS is the clearinghouse of the CME Group.The CME clearinghouse opened its doors inDecember, 2009. CME is a public company andowns its clearinghouse, although it reportedlyhas entered into some arrangement to share someCDS clearing revenues with a founding dealergroup. CMEs greater independence from thedealers, however, is arguably one reason thatdealers do not use CME for clearing. Bankdealers may also fear that having trades clearedthrough CME will accelerate the movement ofderivatives to exchange platforms, whichthreaten the dealers dominance in trading

activity.

It is not just the hurdles to direct participation inclearing that have frozen the buy-side. Everybuy-side institution wants competition andbelieves it to beneficial, but no single buy-sideparty wants to put a substantial amount of itsown money into a structure that may fail. As it isnow, there is significant uncertainty relating tothe margin requirements and transactions costsfor cleared products involving buy-side parties.As the signatories to a March 1, 2010 letter tothe New York Fed have stated: Remaining

impediments to the expansion of buy-side accessto [central] clearing include legal and regulatory,risk management and operational issues.29

The capital threshold at CME of $500 million,however, is much lower than on ICE Trust,which means that at least in principle, CME ismore open to buy-side participants and end-usersof derivatives than ICE Trust. Indeed, knowingthat ICE Trust probably would have a lock, atleast for an initial period on the dealer-to-dealerderivatives transactions, CMEs lower capitalrequirement allows it to target all CDS trades inwhich a dealer is only one side of the trade, and

then perhaps later as its volume increases, usebetter prices and service to bring in the dealer-to-dealer transactions. So far, however, this strategyhas yet to pay off (perhaps because of the otherfactors suggested in the previous paragraph, andalso possibly due to CMEs own growing pains).

28 See the website of ICE Trust:https://www.theice.com/ice_trust.jhtml29 Annex C, page 10.

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As of mid-March, 2010, the CME clearinghousehad cleared less than $200 million in end-userCDS.30

In short, there been no real progress on eitherCMEs clearinghouse or ICE Trust on centralclearing of CDS involving non-dealers, a marketthe dealers have long controlled. Nor has therebeen any progress toward the central clearing ofinterest rate swaps.

ICE Clear Europe began clearing index CDS inJuly 2009, and has since followed by acceptingsingle name CDS. Through the end of 2009, totalnotional volume cleared had exceeded $800billion Euro.31 Like ICE Trust in the UnitedStates, ICE Clear Europe is supported by thedealers.

In theory, the clearing market for all kinds of

OTC derivatives, including those with end-usersor buy-side participants on one side of the trade,is substantial. Morgan Stanley analysts haveestimated that within 2 to 3 years, 63% of alldealer-to-dealer derivatives transactions, 64% ofdealer-to-buy side (institutional purchases), and13% of corporate-to-end-user transactions are orwill be sufficiently standardized so as to becleared by some entity.32

30 Matthew Leising and Shannon D. Harrington, Wall StreetDominance of Swaps Must End, Brokers Say (Update 1),Bloomberg, March 16, 2010.31 Leising and Harrington report that a European entity, LCHClearnet operates the worlds largest clearinghouse forinterest rate swaps. Like ICE Trust, it has minimum capitalrequirements of $5 billion, and also requires members tohave at least $1 trillio

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