Is There A Huge Loophole In Obama's Derivative Reg Reform?

We've been studying the Obama administration's plan to rewrite how derivatives are regulated, and one big concern shows up.

The whole point is to prevent the AIG problem: where one big company has sold so many derivatives to so many financial institutions around the world that if it collapses the whole global economy might collapse.

But the administration's proposal doesn't seem to address all of the issues.

As many of you know, AIG got in trouble by selling credit default swaps, a way to bet on how bonds will perform. So many bonds (especially those toxic asset, subprime-mortgage-related ones) did badly, that AIG didn't have enough money to cover its bets.

Worse, the government didn't know how many of these bets AIG had made, who they made them to, or the exact nature of the bets.

Each credit default swap — like lots of over-the-counter financial products — is custom-made. AIG or JP Morgan or whoever was selling had their own proprietary contracts that they'd custom-build for each customer.

The new rules address the problems in a few ways:

- Banks and other players have to tell the government when they buy and sell these derivatives. That means the government can know how many are out there and who has them.

- If banks and others are buying and selling standardized derivatives, they must trade them on an exchange, sort of like how stocks are traded on an exchange. That way it's more transparent and the prices should more accurately reflect the market sentiment.

- But — and here's the big but — banks and others are perfectly free to continue trading custom-made derivatives as private transactions between two parties.

The proposal calls for:

The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

"Encouragement," not "requirement."

It seems all carrot and no stick: we'd like you to change, but you're perfectly free not to.

Investment banks and others that sell things like CDS have a huge incentive to stay away from exchanges. Trading a standardized product on an exchange is like selling any standardized commodity: you are open to a lot of competition which drives down commissions. If you sell a one-of-a-kind product, though, you can charge through the nose. Think Coca-Cola vs. generic cola.

It seems reasonable to expect that every single sales team on Wall Street will work very hard to convince their customers that they have Very Special, One-Of-A-Kind Credit Derivatives that are far better than the boring old ones traded on the exchange.

The new proposed regs aren't completely toothless. The government will know more about how many derivatives are out there. But the government might not know much at all about the nature of the derivatives. And these things are so strange and behave particularly oddly during times of crisis. Knowing the number but not the kind might not be enough.

We'll see.

CLARIFICATION (Warning: this is primarily for the finance pros who objected to my simplifications above):

Commenter Scott Blanchard wrote:

Virtually ALL CDS contracts are standardized. Which is to say that I can open a position with Goldman Sachs and unwind that position at Citigroup. These instruments will be covered under the Obama proposal and are well suited to being exchange traded. Are there bespoke products available in the derivative market place? Absolutely. But they account for a minuscule portion of the overall business.

Not quite. They are standardized and not-standardized at the same time. How?

The CDS legal structure is set up pretty brilliantly (especially for CDS traders who want nice commissions). There is the blanket ISDA master agreementthat covers most (all?) CDS trades. It is a pre-printed form that covers the basics: tax implications, the nature of corporations doing the trade, how CDS are handled during defaults. This makes trades move quickly, because much of the groundwork is standardized.

But there is a basic rule in finance (and, for that matter, most business): the more standardized something is the less you can charge in commissions. So, CDS traders face a conundrum: more standardization means you can move more of the product and get a higher number of deals, but it means commissions are small. How can you make something simultaneously standardized and not standardized?

In comes the schedule of manual modifications. The trading desk selling the CDS can (and often does) customize things to serve the particular needs of the client. Hedge funds have very different needs than pension funds. Someone truly hedging a long-term position has different needs from someone making a short-term bet.

Compare this to something truly exchange-traded, like plain ol' common stocks. You can't buy some AT&T stock and ask for a special rider that creates custom-made conditions for your special circumstance. (Of course, you can buy custom-made preferred shares if you happen to be Warren Buffet or the Abu Dhabi Investment Authority, but we're talking common here).

So, with the ISDA Master and the manual modifications, trading desks get all the advantages of a fast-moving standardized product with all the commission-boosting benefits of a custom-made product. The client, in theory, also benefits by having something tailor-made to their needs.

Something else worth noting: the ISDA Master agreement and any modifications are private contracts. They are not governed by any financial market regulator.

It seems reasonably clear that we are entering a battle between the Obama administration and those who sell and trade CDS. The Obama administration wants CDS to be fully standardized and traded on an exchange. The CDS sellers don't have an economic interest in letting that happen.

Also, interestingly, many CDS buyers and traders don't want transparency either. CDS can be, frankly, a rather rude product. They are one of the main ways that hedge funds or pension funds or other market participants express a negative view about a company. They want these things quiet and invisible. If you have a long-standing relationship with, say, Bank of America, do you want B of A to find out that you are placing huge bets that they are likely to fail? If you have some super-complicated long-short strategy, do you want all your competitors to know about it? Of course not. Now, any exchange or clearinghouse is unlikely to openly say who took what positions. But, when there's a huge position taken, it's not that hard to figure out who might have taken it.

So, let's say Blanchard is right (he probably is) and most currently-traded CDS would qualify for a new exchange or clearinghouse; it seems fair to guess that lots of CDS operations will be looking for ways to avoid that clearinghouse and all the extra regulation and transparency and lowered commissions it brings with it.

I find it surprising that the Obama administration's opening bid in this war provides for a huge and easily-exploited out. Some are saying the word "encourage" should be taken to mean "force." They say we shouldn't worry about this: the administration has no intention of letting this exception stand.

The administration announcement was just a listing of basic principles. There's a lot of messy sausage-making to be done in Congress and at the regulators. We will see who has the upper-hand in those negotiations. Right now, we're just reading tea leaves.

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