DERIVATIVES STUDY CENTER
www.financialpolicy.org 1600 L Street, NW, Suite 1200
Jettisoning the Safety Equipment
Director, Derivatives Study Center
July 2000, unpublished
The proponents of deregulation have chosen the wrong time to unharness the markets for derivatives – financial instruments such a forwards, futures, swaps and options -- which are known as the "wild beasts of finance." In the face of a possible "hard landing" for the U.S. stock market, the supporters of these derivatives deregulation bills are trying to jettison the regulations that act as safety equipment to stabilize markets and buffer the rest of the economy from their failures.
The House Republican leadership will be trying hard to bring a slew of bills to the floor this September in order prove that they are not a do-nothing Congress. Two of those bills, H.R. 4541 and S.2697, will completely eliminate the regulation of over-the-counter derivatives trading and greatly reduce the level of prudential regulation of futures exchanges. The legislators pushing this plan do so at the nation’s peril.
Despite the pause in the Federal Reserve tightening, there are continued concerns about swings in securities prices. Today’s stock prices, as represented by the S&P500 index, are again near their all time high. Volatility is also high this year; over the past 12 months the NASDAQ Composite index has risen from 2700 to over 5000 and then fallen to 3200 and is now back where it began the millennium at around 4000. In the bond and mortgages markets, the spreads above Treasury securities, which reflect the credit risk in those markets, are very high. Together, this factors should signal a warning to policy makers that the financial markets can still suffer a "hard landing" or what folks outside of Wall Street and the aviation industry call a crash.
Even such major fans of unfettered markets as Fed Chairman Alan Greenspan and SEC Chairman Arthur Levitt have voiced concerns. Stock prices are higher today than when Greenspan described investor attitudes as exhibiting "irrational exuberance." In recent testimony before the House Commerce Committee, Levitt said that investors were driven by "emotion" rather than "intellect."
Given these policy makers’ concerns, then why are they pushing – especially at this time – to deregulate derivatives markets. This amounts to an airline responding to air turbulence, engine trouble and air traffic congestion by removing radar, radio, seat belts, warning lights and instrument panels. Even if the safety equipment were considered less than optimal, or needing "modernization," would that be the best time to cut it loose?
The shear size of these markets warrants close attention. The most recent report by the Bank for International Settlements in Basel reports that worldwide trading in derivatives sums to $190 trillion. That is a conservative measure which includes $102 trillion in trading volume in financial futures and options on regulated exchanges (thus ignoring trading in energy, metals and agriculture) plus $88 trillion in outstanding volume on largely unregulated over-the-counter markets. By comparison, the size of the U.S. stock, bond and mortgage markets combined is less than $28 trillion according to the most recent Federal Reserve flow of funds report. Derivatives create an enormous amount of leverage that is used to take large positions on the securities prices, the yield curve or foreign exchange rates. This leverage magnifies the impact of price movements on the value of derivatives contracts.
In so far that derivatives are used to hedge or otherwise "manage risk," these markets have proven their ability to innovate and grow within the current regulatory structure. As their size indicates, they have mushroomed in the past decade. New derivatives have been created, new clearing systems developed, electronic trading has been adopted and exchanges have merged across national borders – all within the current regulatory structure.
The huge derivatives markets are closely intertwined with other financial markets and many key sectors of the "real" economy. They are an integral part of the markets for stocks, bonds, foreign exchange, energy, home mortgages and farm products. Thus derivatives failures will have a tremendous impact on the housing and commercial real estate sector. For instance, when Long Term Capital Management failed it locked up trading in the interest rate swap market which in turn disrupted the mortgage market. Derivatives trading is a key element of the market for oil, gasoline, home heating oil and electricity. These markets are already under pressure and do not need any additional supply shocks.
It recalls the events of the early 1980s in which policy makers Senator Jake Garn and Fernand St. Germain crafted a bill providing wide-ranging deregulation of Savings and Loans. This lead to the failure of 1,300 financial institutions, cost American taxpayers hundreds of billions of dollars, and depressed the real estate sector of the economy for years. In contrast to the infamy of the names Garn-St.Germain, the names of lawmakers Glass-Steagall are associated with decades of banking sector stability. In the frantic rush to punch out legislation before the election, the sponsors of bills deregulating derivatives will hopefully pause to consider whether they want to hear their names listed as one of the causes when the flight data recorder is dug out of the wreckage. This important legislation should be adequately addressed by the next Congress, and in so doing lawmakers will protect their legacy and good names.
Randall Dodd, Director of the Derivatives Study Center at the Financial Policy Forum in Washington, DC