Director of the Derivatives Study Center
Hearing on the OTC Derivatives Market and
the Regulatory Authority of the CFTC
July 10, 2002
It is an honor to be invited here to offer my insights on the nature of derivatives markets and what should be their proper regulatory framework. In doing so, I hope to add value to this important public policy debate.
The present interest in derivatives market was brought about by a series of problems that include the disruptions in energy markets in the west, the collapse of Enron and the subsequent series of corporate calamities. All of these difficulties have brought to the public’s attention many serious problems with our financial system. In addressing this public concern, we are faced with the dauntingly large and growing number of these problems that poses a genuine problem in conceptualizing the cause and the cure. There are problems with executives, problems with auditors, problems with the Board of Directors, problems with accounting officers, problems with stock analysts and problems with journalists covering the market news. And these are just the bad apples. There are also bad “non-apples” such as inadequate accounting rules, inadequate financial reporting rules, off-shore tax havens, the use of special purpose entities and vehicles, wash trades, sharp trading practices, fraudulent trading practices, the manipulation of energy prices and the misuse of derivatives. I do not think these myriad problems have any one single cause or cure. They may best be described as Yogi Berra said of the Yankee’s loss in the 1960 World Series: “We made too many wrong mistakes.”
I will focus on the role of derivatives because they played a major part in these problems; I believe that it will not be possible to solve auditing and financial reporting problems without more transparent derivative markets; and I believe we cannot expect to maintain safe, sound and orderly trading conditions in our nation’s commodity and financial markets unless derivatives markets play by the same basic rules as the banking, securities and insurance sectors.
Let me explain and justify those claims.
Derivatives – and I use the term to refer to the large class of financial instruments that includes futures, forwards, options, swaps – are traded either on well-regulated exchanges such as the Chicago Board of Trade or in over-the-counter (OTC) markets in an unregulated environment. Since the first OTC interest rate swap was traded 20 years ago, the OTC derivatives market has grown to become one of the pillars of finance along with banking, securities and insurance. The BIS reports (conservatively) that the amount of outstanding OTC derivatives is $111 trillion worldwide -- about 2/3rds of which is in the United States. The volume of trading in exchange-traded futures and options is $445 trillion (and that excludes large classes of exchange traded derivatives such as commodities and single stock options), while the open interest amounts $24.8 trillion. Based on these figures, derivatives not only rival but exceed the size and trading volume of securities markets and the outstanding amount of bank loans and mortgages. Derivatives are definitely a very important part of our financial system and economy as a whole.
Their growth and importance comes from the two important economic functions that they serve: price discovery and risk shifting (also referred to as hedging or risk management). A proper regulatory environment should encourage these activities. Growth in the exchange-traded derivatives markets is a testimony to this. Unfortunately, their growth also comes from unproductive, if not nefarious, uses such as the distortion of financial reports to hide debt, the fabrication of income, tax avoidance and outflanking prudential regulation of securities, banking and insurance activities. A proper regulatory environment should sharply discourage these activities.
Derivatives play an especially important role in the energy and metals markets. Energy use in the U.S. economy is approximately $600 billion a year, and the number and amount of transactions needed to produce, transport and distribute that 98.5 quadrillion BTUs of energy is many times that $600 billion. The exact amount of derivatives in these markets is unknown because there are no reporting requirements or voluntary efforts. However, in my Special Policy Brief of February 2002 entitled “The Bigger They Come, The Harder They Fail: Enron’s Lesson for Deregulation,” I estimated the dollar value of Enron’s derivatives book for year end 2000, and found that it included $758 billion in energy derivatives and another $16 billion in interest rate and foreign exchange derivatives. To this should be added the trading of Duke, Dynegy, Williams, El Paso and the others. The sum is mostly likely to be more than ten-fold the amount of final energy use. In this large and crucial sector, it is imperative that these markets work in a safe, sound and efficiently.
In order that derivatives markets yield the economic benefits of price discovery and risk management, and are devoid of the social costs from unproductive uses, the following market conditions are needed.
1) Prices, and other key market information, are observable to everyone, i.e. markets are transparent;
2) prices are regarded with a high level of integrity (not viewed as tainted by fraud or manipulation;
3) transactions in derivatives instruments are conducted in an orderly manner (markets should not freeze or become illiquid, and price movements should not be excessive); and
4) the derivatives transactions are managed with sound credit practices.
Let me briefly elaborate in order to more thoroughly explain each of these facets. Everyone needs to observe market prices – bid, offer and execution price – in order that each can buy at the lowest and sell at the highest possible available price. It is an inefficient market where participants are paying too much or receiving too little.
In order to protect the integrity of prices, the markets must not be affected by fraud or manipulation. The reason for this is stated beautifully in earlier versions of the Commodity Exchange Act: derivatives prices are "affected with a national public interest. The prices in such transactions are generally quoted and disseminated throughout the United States... for determining the prices to producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce.”
Derivatives trading should be orderly. These markets are linked to other markets throughout the economy, and so disruptions occurring in one can be transmitted to the others. Liquidity is a crucial feature of a well organized market, while “freezing” and illiquidity and excessive price movements are not.
Derivatives are highly leveraged transactions that involve large degrees of price exposure. This use of derivatives creates large amounts of credit risk, or the risk that the other party will not fulfill their obligations. In order to minimize this risk of contract failure, and the systemic risk that failure is transmitted from counterparty to counterparty, the capital and collateral must be well managed. Otherwise, failure threatens to cause losses and bankruptcy throughout the economy, and the derivatives market faces a loss of confidence and ceases to yield the beneficial services of price discovery and risk shifting.
Yet these conditions that are needed for efficient and beneficial markets are not being met in the actual market practices of OTC derivatives trading. If markets do not produce proper trading practices on their own, then it is in the public interest for rules and regulation to help establish better practices.
The appropriate level of regulation for OTC derivatives market should have the following three elements:
1) registration and reporting requirements;
2) capital requirements for institutions and collateral requirements for transactions; and
3) orderly market trading rules.
Again, allow me to briefly elaborate.
Registration requirements help prevent fraud on the market by ensuring that individuals involved with customers, end-users and other dealers are competent and do not have criminal records for fraud. If someone is convicted of securities fraud they are barred from securities brokering for life. Yet they can go to work for an unregistered dealer such as Dynegy the next day. Registration that is conditional upon the successful performance on competency exams assures that individuals can be held accountable for their actions.
Reporting requirements make markets more transparent. It gives all market participants equal access to prices and other key market information, and it gives to regulators the ability to observe markets in order to detect problems before they become a crisis.
All OTC derivatives transactions should be adequately collateralized. Enron’s failure exposed several bad industry practices, and these should be corrected. The current market practice, insofar as there is one, is dangerous. It requires a firm to become "super-margined" if its credit rating drops, and thus initiates a large increase in the need for collateral just at the time the firm is experiencing problems with inadequate capital. This amounts to a crisis accelerator. Exchange-traded derivatives have well managed collateral, called margin, and that is a major reason why the flight to quality following Enron’s failure lead to the NYMEX. If a well regulated market had not been there to act as a safe harbor, the consequences to the market would have been greater.
Derivatives dealers should have adequate capital. Dealers who are banks or securities broker-dealers do face capital requirements – although as banks and broker-dealers and not as derivatives dealers per se, but entities such as Enron who were major dealers in energy, weather, and credit derivatives amongst others do not face any capital requirements. Capital is important because it serves as a buffer to dampen losses at the dealer from becoming defaults and losses at the dealer’s trading counterparties and in turn their creditors and trading counterparties and customers.
OTC derivatives dealers should be obligated to act as market makers. They capture the advantages of their privileged position in the market, and so they should bear the responsibility – like dealers in U.S. government securities (the most efficient and highly regarded OTC market in the world) – of ensuring market liquidity by maintaining bid-ask prices continuously through trading hours. These markets should also be subject to rules regarding position limits and price movement limits like securities, options and futures exchanges. Lastly, OTC markets should be encouraged to employ clearing houses in order to increase the efficiency of the clearing and settlements process and to decrease the threat of systemic risk.
These rules are not burdensome. First, reporting is all but free of cost. Merely cc: the regulatory or supervisory authority in the process of confirming trades. Second, these rules are basically the same as those that apply to banking, securities and insurance – the other pillars of the US financial system. If they prosper while operating under these rules, then derivatives market will too.
Together, these three rules will provide a solid foundation for a remedy to such recent problems as:
· Wash trades
· Distortion of balance sheet and other aspects of financial reports
· Disrupt trading
· Hampering the work of auditors to determine what is actually going on
· Creating contagion or the transmission of market disruptions to other firms, industries, and economies and to their investors and employees and creditors.
These few prudential market rules will amount to a fundamental improvement in drawing the virtues from these markets while protecting against their misuse. This will restore investor confidence in the derivatives as well as securities markets and the overall economy.