Bob Litan on Derivatives Reform 1: Failure even with a Win?

Bob Litan of the Brookings Institute has a new paper out on derivatives reform (full pdf, summary). The paper is called “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties” and it’s a must read for two very important reasons.

Before we get there, I agree with his recommendations for regulating the over-the-counter derivatives market and especially the credit default swap market (CDS): create a strong presumption for over-the-counter derivatives to go through clearing, and to be traded on an exchange with pre-trade price transparency. Those that can’t should have margins posted and have post-trade price and volume transparency. This will be a major battle ground in the financial reform debate, and learning these terms will put you in a better spot to follow it. Litan walks you through each of the terms.

As his title states, Litan is worried about the “Dealer’s Club” of the major derivatives players. I particularly like this paper as the best introduction to the current oligarchy that takes place in the very profitable over-the-counter derivatives trading market and credit default swap market. I’m going to just give the high level overview of what he says (italics in original, my bold):

I have written this essay primarily to call attention to the main impediments to meaningful
reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks…I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being
widely discussed are adopted
— that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned…

Here, of course, I refer to the major derivatives dealers – the top 5 dealer-banks that control virtually all of the dealer-to-dealer trades in CDS, together with a few others that participate with the top 5 in other institutions important to the derivatives market. Collectively, these institutions have the ability and incentive, if not counteracted by policy intervention, to delay, distort or impede clearing, exchange trading and transparency

Market-makers make the most profit, however, as long as they can operate as much in the dark as is possible – so that customers don’t know the true going prices, only the dealers do. This opacity allows the dealers to keep spreads high…

In combination, these various market institutions – relating to standardization, clearing and pricing – have incentives not to rock the boat, and not to accelerate the kinds of changes that would make the derivatives market safer and more transparent. The common element among all of these institutions is strong participation, if not significant ownership, by the major dealers.

So Bob Litan is waving a giant red flag that the top dealer-banks that control the CDS market can more or less, through a variety of means he lays out convincingly in the paper, derail or significantly slow down CDS reform after the fact if it passes. Who are these dealer-banks?

Litan never names them, but footnote 39 refers to the top 5 banks/BHC at the OCC’s Quarterly Report on Bank Trading and Derivatives Activities controlling 96%-97% of the market for the top 25 BHCs. And from there, the top four are: 1. JPMorgan Chase (assets: $2,000bn) 2. Goldman Sachs ($850bn) 3. Bank of America ($2,200bn) 4. Citibank ($1,856bn). This doesn’t get at the entire market, as the OCC only can see US commercial bank data, but it gives you a sense of the players.

Litan never mentions this as part of a group of solutions, but It is worth noting that these four players, all TARP recipients, would be turned into 15 players with a size cap of around $500 billion dollars. There are good arguments against a size cap, but the two leading ones, (1) that there would be a cluster of banks around the cap and (2) the broken pieces would be perfect clones of the whole piece, aren’t at all relevant for the issue of an oligarchy capable of derailing credit default swap regulation and colluding to keep the margins high through market and institutional control.

If you thought we’d at least get our arms around credit default swap reform from a financial reform bill, you should read this report from Litan as a giant warning flag. In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have. It’s not Matt Taibbi, but it’s much further away from a “everything is actually fine and the Treasury is in control of reform” reassurance. Which should scare you, and give you yet another good reason for size caps for the major banks.

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14 Responses to Bob Litan on Derivatives Reform 1: Failure even with a Win?

  1. Pingback: “The Derivatives Dealers’ Club” « The Baseline Scenario

  2. frankl says:

    i thought all otc markets would get brought onto exchanges solely for the opportunity to curtail tax evasion, but i guess not

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  6. Venerability says:

    There are two things that I believe need immediate attention:

    First and foremost should be the banning of double- or triple- or nth-degree derivative vehicles – on the short or long side – introduced just a few years ago to enable everyone to trade easily and in very liquid fashion for or against indices, currencies, or commodities.

    These vehicles encourage even rank amateurs to “bet” – and it is just betting – for or against a currency, commodity, or index they like or don’t like at the click of a mouse. They lead to irresponsible and eventually unsustainable momentum plays that distort domestic and international markets.

    I strongly believe, for example, that the extreme shorting of Oil via these derivatives in the spring of 2008 led to the oil-spike to 140-plus in the summer of 2008, a major contributor to the market crash. The spike was not caused by panicky buying of Oil from the long side. It was caused by panicky covering of Oil from the short side, by me-too amateur hedgies and hedgie-wannabes who had previously used the double- or triple-short liquid derivative vehicles.

    These particular derivative vehicles contribute nothing to our markets except potential instability. They should banned outright.

    My second major concern is the ability of the trading desks at the popular brokers to “bet against” their customers on a regular basis. They now do this literally routinely, saying it protects them.

    Maybe so, but it works against their customers. It is the ultimate outcome of the abolition of the so-called “Chinese Wall” that used to separate brokers’ trading entities from the parts of their businesses that dealt with clients.

    I think the abolition of the “Chinese Wall” began all our market problems. Maybe we can start building it again.

  7. admire mapaire says:

    how does trading on derivative markets result in bank failures,what risks are associated with such trading.

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