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                                                                                                           Washington, D.C.   20036



   On Not Learning The Lessons

   Of Long-Term Capital's Failure


                                    Randall Dodd, Director, Derivatives Study Center

                                    September, 2000 -- unpublished



Learning from mistakes is finding silver linings to dark clouds. Failing to learn from mistakes is condemning oneself to repeat them.


Congress is rushing to deregulate derivatives markets – the markets for transactions such as futures, options and swaps. In order to not be deemed a do-nothing Congress, the House Republican leadership pressured committees to report out legislation in July, and they will be trying to bring a bill to the floor this September. In doing so, the advocates of deregulation seem to have completely forgotten the two key lessons found in the near disaster that was the collapse of the hedge fund known as Long Term Capital Management. LTCM, you may recall, leveraged $5 billion in capital to control $125 billion in assets and $1.4 trillion dollars in derivatives (mostly interest rate swaps).


Lesson one is that a major problem in over-the-counter derivatives markets stems from their lack of transparency. Lesson two is that a major source of vulnerability in financial markets comes from highly leveraged transactions and institutions, some of which are largely unregulated.


Do these deregulatory proposals show that these lessons have been learned? Not the first lesson. The proposals not only fail to make any improvements in transparency in the over-the-counter derivatives markets, but they will actually reduce transparency in futures exchanges.


The over-the-counter (OTC) derivatives markets have never been subject to any meaningful reporting requirements. The only public information about these markets comes in quarterly or semi-annual reports from the Treasury’s Office of Comptroller of the Currency and the Bank for International Settlements. However this information is limited to the aggregate volume of outstanding volume and open positions in a few major categories of derivatives. It is not enough information, and it is not of sufficient frequency, for the government or market participants to spot pressures or vulnerabilities building up in the markets.


The futures exchanges and futures brokers are presently required to report on daily trading volume, prices, open positions and most importantly large trader positions. This information has been used effectively by the Commodity Futures Trading Commission, which meets weekly to discuss surveillance issues, to detect and deter manipulation as well as to head-off potential "disorder" in the markets from the lack of deliverable supplies. These preventative measures enable the Commission to identify markets and traders with proportionately large market shares and contact them in order to inquire as to their purpose. If it does not relate to a valid purpose, it allows the Commission and the futures exchange to demand an orderly liquidation of the positions.


Despite the lessons from Long-Term Capital and the successes of the CFTC in market surveillance, the current proposals will eliminate the reporting requirements for trading on some of the new regulatory designations for exchanges. This will actually reduce transparency in the derivatives markets.


The supporters of deregulations will argue that there is no reason to be concerned with manipulation. They claim that it does not happen too often, and that it cannot happen in large financial markets. The facts are to the contrary. Even the enormous and sophisticated market for U.S. Treasury securities has been hit with a couple a major attempts at manipulation in the past decade, and the Federal Reserve Bank of New York has recently warned about problems in the repo market for Treasury Securities. The market for some commodities is larger than that for some financial instruments, and the grand manipulation of the global copper market was discovered only a few years ago – and it was discovered by the CFTC even though the manipulation was organized out of Japan using a British futures exchange with credit supplied by a French bank.


Another dimension to the concern with manipulation is the degree of concentration in some of these markets. The most recent data from the Office of Comptroller of the Currency shows that the top four dealer banks are counterparties to 91% of interest swaps held by U.S. banks, and that the largest dealer Chase has over 42% of the market to itself. This is not a monopoly, but it is without question highly concentrated.


What about the lesson on the dangers of leverage? After the LTCM debacle, Treasury official Lewis Sachs testified before the House Banking Committee that the question of how to constrain of the leverage of hedge funds was "the central public policy issue raised by the LTCM episode."

This too seems to have been forgotten. Deregulation will eliminate the possibility of addressing such "central public policy issues" by completely excluding OTC derivatives from federal regulatory authority. Gone will be the ability to set minimum standards for collateral or margin, to put limits on the size of speculative position (as is currently the practice on futures exchanges), and to put the same obligations on the dealers in OTC derivatives as is placed on securities dealers who are required to make a market – and thus assure market liquidity – by maintaining bid and offer quotes.


Altogether, the deregulation of derivatives markets is an odd policy response to the long economic expansion and the longer bull market – instead of protecting our lead, these policymakers are taking it as an opportunity to play more recklessly.


Yet there is no urgency, and thus this rush to deregulate is needlessly risky. The prudential policy course to pursue is first allow time and resources to study these markets – about which too little is known – since the President’s Working Group’s report contained no such research or analysis. Once more is known, a broader public can participate in the policy debate. (The recent round of Congressional hearings have heard mostly from derivatives dealers and federal regulators.) And what will hopefully be learned are the lessons from past mistakes and how to adopt policies so that they are not repeated.


Randall Dodd, Director of the Derivatives Study Center at the Financial Policy Forum