Mar 13

Bravo, Chairman Gensler!

Posted by Kristjan Velbri | Posted in Financial Regulation | Posted on 13-03-2010

Gary GenslerChairman of the CFTC, Gary Gensler has really grabbed the bull by its horns – he is proposing wide-ranging reform of the over the counter derivatives market, with a special focus on credit default swaps. I understand that for some of you this might look like gibberish, but it is important to understand that derivatives played an important role in the credit crisis (see this link for explanation). Without credit default swaps, AIG wouldn’t have needed a bailout. Lehman would not have failed, were it not for their huge (off-balance sheet) position in mortgage derivatives such as CDOs and synthetic CDSs.

Here are some excerpts from Mr. Gensler’s speech, the full version of which can be downloaded here: Keynote Address of Chairman Gary Gensler, OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference. All highlights are my own.

The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story. They were at the core of the $180 billion bailout of AIG. The reliance on CDS, enabled by the Basel II capital accords, allowed many banks to lower regulatory capital requirements to what proved to be dangerously low levels. They also contributed to weak underwriting standards, particularly for asset securitizations, when investors and Wall Street allowed CDS to stand in for prudent credit analysis.

Mr. Gensler goes on to talk about reform:

Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Here, Mr. Gensler makes an excellent point regarding the right to buy insurance. It is not known to many that credit default swaps can be bough ‘naked’, that is, you can buy insurance on an institution that you don’t even have stake in. That would be like buying fire insurance on your neighbor’s house -  it doesn’t take a college degree to figure out what happens next to the house in question. Mr. Gensler:

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

Hat tip: Barry Ritholtz
Image courtesy Businessweek.

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