Explaining FinReg: Derivatives
I've been dreading this one. Derivatives are rough sledding. Explaining futures, options and swaps is the blogger's version of the Oregon Trail: It'll take months, and you'll probably lose most of your people along the way. Maybe to dysentery (but maybe not). But you have to get into it: If we don't get derivative reform right, FinReg isn't worth the paper it's printed on.
Here's the good news: You don't need to understand the different types of derivatives. All you really need to know is that financial firms trade derivatives, they're worth an extraordinary amount and there's a category of them that's almost totally unregulated. That's a big part of the reason why the financial crisis was as severe as it was: We had no idea how many derivative contracts these major firms had with each other -- and with everyone else. So when Lehman fell and other banks threatened to follow, no one could predict the consequences. "What we mean when we say a company is 'too big to fail,'" says the Roosevelt Institute's Mike Konczal, "is that they have too much derivative exposure too fail."
So, derivatives: bets that other firms have with one another and that are big enough to crash the financial system if a firm defaults, but not bets that we know about or regulate. That's not so hard, right?
And that's the end of the derivatives lesson for the day. The concept you really have to know about isn't derivatives, but the answer to the derivatives problem: The clearinghouse. First, here's a graphic that won't make sense for a minute but will be useful while reading the next few paragraphs:
Right now, these trades are made bilaterally. That is to say, I make a deal with you for a price that we both agree on. AIG demonstrates the problem with that strategy: One of us might sign more of these deals than we can actually afford if the bets don't go our way.
The clearinghouse solves that problem. It stands between me and you and manages our bet. So when we make a deal, we'd both have to post up some initial money to the clearinghouse. And we have to update that money every day. The trade is "marked to market," which is to say, it's evaluated based on what would happen if it had to be settled today. Whoever lost ground that day has to post more money to the clearinghouse. And all participants have to give the clearinghouse a bit more money beyond that in order to make doubly sure the clearinghouse can pay the bets back.
This does a couple of things. First, it means we know who has bets with whom. Rather than a web of derivatives, it's a map. Second, it means we know everyone can pay off their bets, and we can see if one firm or another is suddenly taking massive hits every day. There would be no AIG-like situation, where they seemed to be doing fine and then, all of a sudden, seemed about to blow up the financial system. We would've watched the wave build rather than only noticing when it was breaking atop us.
So that's the first, and most important, step. The second piece of the puzzle is exchanges. Stocks are traded on exchanges. So are some derivatives. The upside of an exchange is that it creates pricing transparency. If you and me make a deal and don't tell anyone about it, no one knows the price. That's fine for you and me, of course, but what we saw in the financial sector was that we had trillions in derivatives that we couldn't price. Figuring out a price, in fact, was the whole point of Tim Geithner's Public-Private Investment Partnership program.
Wall Street doesn't want exchange-trading because, well, it will reduce their profits. They can skim much more off the top if they're negotiating one-on-one than if they're in a competitive market where everyone can see prices. It's the difference between shopping in a flea market and shopping on Amazon.
The other major policy proposal is Blanche Lincoln's effort to spin the parts of banks that trade these derivatives off from the rest of the bank (at least if the bank wants access to the Federal Reserve's low rates). So rather than there being a Bank of America that trades credit default swaps and holds your deposits, there would be a Bank of America that held your deposits and a BofA spin-off that traded derivatives. Experts I spoke to were split on this, with some saying it's a smart move to break apart the risky parts of banks from the commercial deposit divisions but more saying that it's unnecessary and likely to create a lot of disruption in a fragile economy.
The hiccup in all this is what's called "the end-user exemption." There are two types of folks who use derivatives: Companies who are legitimately hedging future risks (say, an airline that's worried about the price of fuel in 2015) and firms -- and sometimes companies -- that are just trying to speculate. The legitimate hedgers don't necessarily need to be regulated in the same way the speculators do. The trick is writing that exemption narrowly enough that speculators can't slip through the door as well.
An important note to all this: Unlike most of financial reform, which is really about changing the powers of regulators, this is really a reform of how Wall Street conducts its business. It is, in other words, "Wall Street reform," which is the term Democrats prefer to use. And if the end-user exemption remains limited, and clearinghouse and exchanges become the norm, we're in pretty good shape: Clearinghouses will take care of the main risks derivatives pose to the system. Exchanges will allow us to price the products and detect movements in the market. Get this right, and financial reform might just work. Get it wrong, and it definitely won't.
Graph credit: Cantwell office.
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