Darrell Duffie on Regulating Foreign-Exchange Swap; Moderate 1990s Republican Style Financial Reform?

This is interesting. Well-respected Stanford University financial economics professor Darrell Duffie comes out in favor of regulating the foreign-exchange swap market:

“There’s as much reason to clear this class as any other class of derivative,” Duffie said in a telephone interview today. The market, which consists of all the largest global banks, for foreign-exchange forwards and swaps is $25.6 trillion in notional value, according to the Bank for International Settlements.

“If those were to suddenly revalue, we don’t know whose ability to pay is threatened,” Duffie said.

‘Critical Gap’

The absence of publicly available data on the average life of currency forwards and swaps is “a critical gap in our knowledge,” wrote Duffie, who serves as a member of the Federal Reserve Bank of New York’s financial advisory roundtable.

“Equity and commodity derivatives were not exempted from the clearing and other requirements of the Dodd-Frank Act,” Duffie wrote. “Additional analysis, if carefully conducted, would likely reveal that such exemptions are inappropriate.”…

Duffie said he is proposing to create clearing contracts for foreign-exchange forwards and swaps that would be margined at clearinghouses during the life of the trade and would then be settled through the standard exchange of currencies like U.S. dollars and Japanese yen.

He said he favors clearing and settlement systems for all financial markets with substantial risk….

Price swings are also greater in foreign-exchange swaps and forwards than in credit swaps, Duffie wrote.

“Absent the disclosure of data allowing a proper quantitative analysis, the total effective amount of counterparty risk in the FX derivatives market could be of a magnitude similar to that of the market for credit-default swaps,” Duffie wrote. “Unless treated by regulation, counterparty risk in the FX derivatives market could easily grow substantially.”

Duffie is the author of the financial engineering staples Credit Risk: Pricing, Measurement, and Management and Dynamic Asset Pricing Theory.  We have previously discussed regulating the swaps market here.

Duffie was also a member of the Squam Lake Working Group on Financial Regulation, and I remember their chapter on clearinghouses and exchanges was strong in terms of derivatives regulation.  That chapter was very much based on Duffie’s work, so it doesn’t surprise me he is strong on derivatives reform as it is being implemented.

Squam Lake, Dodd-Frank, Moderate 1990s Republicanism

Ezra Klein had a very good observation a while back: “President Obama, if you look closely at his positions, is a moderate Republican of the early 1990s. And the Republican Party he’s facing has abandoned many of its best ideas in its effort to oppose him.”

I’ve been meaning to try and develop this argument with regards to financial reform, so please jump in if you’d like.  Let’s make three assumptions:  (1) I’m not sure how to best describe the political economic default policy outlook of the participants of the Squam Lake working group – people like John H. Cochrane, Darrell Duffie, Frederic Mishkin, Raghuram G. Rajan. Let’s say it’s moderate Right, what we could comfortably call early 1990s moderate Republican.

(2) You can take the Squam Lake report on what financial reform should look like as a kind of moderate Right/moderate Republican view of financial reform post-financial crisis. (3) Dodd-Frank is conceptually similar in theory and very similar in practice to the Squam Lake’s report.

If those pan out, Dodd-Frank financial reform act, like cap/trade and health-care reform and others, would be the equivalent of a moderate Republican approach to finreg in an age where moderate Republicans have become extinct.

It’s been a while since I’ve read it, but I remember, when it is compared to Dodd-Frank, Squam Lake was weaker on consumer protection, conceptually stronger on derivatives (with a purposeful eye towards eliminating regulation arbitrage, hence Duffie’s no exemptions for foreign-exchange and little emphasis on end-user exemptions), and focused on coco bonds as the major companion piece to resolution authority.

I have to think this through more. It was distinctly not the “just put everything in bankruptcy”  approach of conservative proposals like the “Chapter 14” idea proposed by the economist John Taylor and others at the Hoover Institute as well as congressional Republicans or the neo-Brandeisian approach of size and scope regulations that people on the left (or those in favor of stronger regulation broadly) wanted.  What’s your take?

Again like other Obama initiatives, Republicans completely opposed Dodd-Frank.  I knew early on when only one Republican voted for derivatives reform out of House committee that the entire thing was going to be a mess, placing the GOP significantly to the Right of where a moderate Republican would have ended up.

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1 Response to Darrell Duffie on Regulating Foreign-Exchange Swap; Moderate 1990s Republican Style Financial Reform?

  1. Ted K says:

    Great post. I wish I could get Duffie’s books “on the cheap”. Alas, the pains of being a poor boy. I don’t know why those books are always so damned expensive. I can get roughly the same size Econ books published by MIT and Princeton for $11–$15. I guess so few people actually read Asset Pricing and derivatives stuff the returns to scale are very bad for the publisher. Mike, I want to cry now. Waaaaahhh!!!!

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