Much has been said and written by members of the media and government about the

Question

Much has been said and written by members of the media and government about the dangers of unchecked speculative overuse of options and other derivative security instruments. Some economists and commentators have responded, however, that these instruments are most useful in helping investors manage risk in their portfolios, making them important tools which should not be discarded. What is your opinion about how and whether derivative markets should be regulated? Options, in particular, allow a portfolio manager to increase or decrease portfolio risk. What are some examples of using options to increase risk and decrease risk?

Explanation / Answer

Some allowance should be made for financial innovation and customization. All the proposed legislation for derivatives’ reform can be evaluated using several policy options that are believed, in varying degrees, to reduce systemic risk and improve the efficiency of the derivatives’ markets. They are Centralized clearing. Clearing insulates counter parties from one another, provided that the clearinghouses are themselves well designed and capitalized. In addition to any direct reductions in counter party risk, clearing reduces the sort of run-on-the-bank behavior that likely quickened the failures of Bear Stearns and Lehman. Improved price transparency. Markets tend to be more efficient when the “going price” is well known by market participants. OTC derivatives’ markets have limited price transparency. Some analysis should be devoted to the question of which markets deserve additional levels of price transparency, for none of the main legislative proposals require such transparency. Improved position transparency. Another issue is the availability of data on the sizes of derivatives’ positions, which would allow the monitoring of risk concentrations with systemic implications. Concerns exist, however, about what amount and type of data are appropriate to be disclosed and to whom. Proposed legislation calls for all OTC derivative trades to be reported to qualified trade registries. Those data will be available to regulators, with some summary information possibly provided to the public. Migration of over-the-counter trading to exchanges. More extensive use of electronic trading platforms and of the kind of price transparency found in TRACE (Trade Reporting and Compliance Engine) would reduce the inefficiencies associated with OTC market opaqueness. Legislation appears likely to require that all “standardized” derivatives be traded on exchanges or on “alternative swap execution facilities,” subject to exceptions allowed by the enforcing agencies: the Securities and Exchange Commission and the Commodity Futures Trading Commission. Forcing derivatives’ trading onto exchanges by regulation should, however, be done with caution. Speculative position limits. It has been proposed that speculative derivatives’ trading should be severely curbed or even—in the case of CDS markets—outlawed. Such proposals, however, are based, at least in part, on a misconception of the role of speculation. Outlawing the speculative use of credit default swaps to buy protection would have the unintended consequences of reducing market liquidity (because those selling protection would have less incentive to incur the costs of remaining informed and active traders) and of driving this form of speculation “under the radar,” through the use of less-effective and transparent types of financial products. Allowance for customization and innovation. Derivatives that are not easily cleared or exchange traded are typically those customized to suit the specific business uses of investors, for which there should be some tolerance for innovation and customization. Economic efficiency is harmed if those with commercial needs for hedging are forced into standard derivatives’ positions that are relatively poor hedges or if derivatives’ markets are unable to innovate along with changes in the economy. In summary, the increased use of central clearing represents the most powerful way to reduce the systemic risk arising from OTC derivatives’ markets. Some key steps that regulators should take are (1) pressuring dealers to adopt specific numerical targets for lowering exposures (before collateral) on uncleared derivatives positions, (2) increasing regulatory capital requirements for uncleared-versus-cleared derivatives, (3) persuading dealers to clear a greater fraction of dealer-to-customer positions, and (4) fostering international coordination in the regulation, supervision, and failure resolution of clearinghouses. It would be counterproductive, in my opinion, for regulators to reach for legal definitions of the types of derivatives that are to be cleared.

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