An Argument for Exchanges and Swap Execution Facilities

Over at FT Alphaville, Craig Pirrong has a response to my concerns that OTC derivative regulation has major loopholes.

Pirrong validates my worries as he also believes these loopholes are real, but instead chooses to cheer them on:

“That is, whereas reform advocates envisioned that under the new law swaps would be traded almost exclusively on exchanges or transparent, exchange-like venues, they claim that the new language would perpetuate the existing ways of trading swaps in scary “dark” markets.

This is not a bad thing at all – contrary to what some have argued…the authors are to be commended. To the extent that the bill still imposes unnecessary mandates, they are to be criticized.”

He goes on to press that exchanges were tried in the agricultural and commodities act and failed, and that my concerns reflect a “standardization religion.” There’s a couple of things going on, and that baseline post was fairly insider baseball, so let’s back up and talk through some things here.

For Exchanges

Let’s define some terms. Many people are comfortable forcing OTC derivatives to be forced into clearing (though I don’t think the author above does). I like that, but I and others worried about financial reform want to see more. Let’s talk about exchanges versus clearing. Now as opposed to the FT article, I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world. What I am worried about is that the swap execution facility will move away from a formal “trading facility” definition towards a vague nebulous definition of whatever people can get away with.

So what are the features that I want to see? I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.

Right now people will tell you that clearing derivatives still gives market prices, and these prices can be transparent with a few tweaks. However a clearinghouse only sees one price, the price at which the deal was struck, and it only sees that price after the deal is completed. So yes, this is a history, but it is only a partial history. A fuller price history will give us information available for use by many different parties to carry out their own transactions, the very heart of what prices are supposed to do in a market.

Now some argue that some financial instruments, say a CDS contract, can’t be forced into clearing, since it would be unprofitable to post the margins and collateral necessary to clear. Your response should be: fantastic! This is an example of where sunlight is the best disinfectant. If an instrument trades only because people are uncertain about how it will ever get paid off, or if an instrument trades only because there’s an implicit (and nowadays, explicit) government guarantee of using taxpayer money, and without this guarantee nobody would be involved, then you don’t actually have a market.

Better Than Clearing

Others argue that having clearinghouses plus a certain amount of disclosure is just as good as having exchange-like mechanisms. I think there are a few things missing from this that you would get with exchanges and SEF.

The first is price transparency, where those looking for swaps to manage risk could find the best price cheaply and easily. The more actively traded the contracts become and the more transparent prices get, the narrower the spread. There are less economic rents, and markets becomes more efficient. The second is that a high resolution audit trail gives managers and regulators something to investigate and observe performance. This is good for managers, who can help resolve the obvious principal-agent problems that we see with the stark promotion/bonus/risk tradeoffs in finance. It is also good for regulators, who will be able to see both corruption and systematic financial risks easier.

The OTC market needs to change. To whatever extent it had problems before, the battle cry of “No More Lehmans!” has given everyone a perverse incentive to participate with Too Big To Fail banks. How can a small dealer compete in this new landscape?

Several people have been questioning whether or not the bills Obama and the Democrats have put together are too big, and whether smaller incremental changes would be a better way to go. Matthew Steinglass had an excellent post in the opposite vein a while back regarding health care, where he noted that each plank of reform moving by itself causes problems, and it is only when they move together can reform actually take place. This is crucial with OTC derivatives, as we can’t make Too Big To Fail progress without substantial new OTC derivatives regulation. Living wills, et al only make sense in the context that counterparty risk is more clearly defined, and that the playing field is leveled for more players.

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6 Responses to An Argument for Exchanges and Swap Execution Facilities

  1. financeguy says:

    Beautiful post, Mike. Agree completely with the transparency point. The CDS observation was priceless too.

  2. jck says:

    “The best metaphor for clearing, if you are unfamiliar, is like a gambling bookie. The bookie is trying to match up people for and against a sport bet, and make the most money by just being in the middle. If someone is gambling too much, he can demand some cash as collateral upfront. That’s clearing.”
    no, it’s not clearing, it’s principal market making.

  3. Mike says:

    Financeguy – thanks for the kind words.

    jck – Yeah, I see that, and I just yanked that poor metaphor. Thanks for catching it.

  4. csissoko says:

    My objection to Pirrong is his reading of history: His evidence for the failure of what he calls “one size fits all” is that laws passed in the 1930s outlawed OTC financial derivatives — so they had to be changed after the 80s.

    (1) I thought the world and the US experienced stellar grow during a big chunk of that period when these derivatives were outlawed.

    (2) Isn’t the 80s pretty much when finance started to grow to big and the real/financial relationship started to go completely out of whack? As Paul Volcker has pointed out: Is there any solid evidence that OTC financial derivatives served any purpose except to make it easier for financiers to extract rents from the real economy?

  5. Pingback: FT Alphaville » Further reading

  6. dsquared says:

    If an instrument trades only because people are uncertain about how it will ever get paid off, or if an instrument trades only because there’s an implicit (and nowadays, explicit) government guarantee of using taxpayer money, and without this guarantee nobody would be involved, then you don’t actually have a market.

    but by this standard (if you consider the LIBOR fix and the interbank lending system), the money market doesn’t exist.

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