The world listened closely as Timothy Geithner rambled on about the need to create global financial regulations for derivatives in order to prevent another “race to the bottom” a la the 2008 Credit Crisis. This is all fine and well, except for the fact that his call to action was incredibly vague and largely improbable.
The problem is that Geithner is not the first, and will not be the last, to call for these kinds of regulations. Gordon Brown, former head of the International Monetary Fund Jacques de Larosière, and financier George Soros are just some of the individuals who have been calling for such regulations since 2008, but realistically, what does it all mean?
To understand the criticisms against derivatives, it’s important to understand exactly what a derivative is. A derivative is a contract that derives its value from an underlying asset. As such, the futures contracts traded by CTAs in the managed futures space are, technically, derivatives. However, when talking about global financial regulation, and the 2008 crisis in particular, the bulk of the conversation centers around over-the-counter or OTC derivatives.
These over the counter derivatives are traded privately between two parties (usually large banks or hedge funds and banks), which means there’s no one checking to make sure everyone has the money necessary to participate in the trade (besides the two parties...)
In contrast, futures contracts such as Gold futures or eMini S&P futures traded through the CME are “exchange traded” derivatives, meaning they are guaranteed and cleared by an exchange like the CME. This allows those who trade the contracts to forego the need to check on the creditworthiness and counterparty risk of the person on the other side of the trade, as the CME itself for all practical purposes is considered on the other side of every trade.
With the bulk of the managed futures industry (90% by our guess-timate) managing accounts via exchange traded futures – managed futures are not really part of the problem being discussed when we hear about derivatives (with exchange traded derivatives volume dwarfed by the volume of over the counter derivatives by a factor of 100 to 1). And, exchange traded derivatives are already regulated heavily via the Commodity Futures Trading Commission (CFTC). The problem when we hear of the need to regulate derivatives largely centers around over the counter or off exchange derivatives.
Dr. Dean Duffie of Stanford University explained the role of OTC derivatives best:
The financial crisis was exacerbated by derivatives’ markets in two basic ways. First, insurance companies such as AIG, Ambac, and MBIA used [over the counter, non regulated] credit default swaps (CDSs) to sell protection on collateralized debt obligations (CDOs) backed by subprime mortgages to such an extent that those companies were severely impaired when the CDOs experienced large losses from mortgage defaults. This in turn contributed to the weaknesses of the banks that had bought these CDSs, relying on that protection. The second exacerbating factor was the failure of the large investment banks. The problems faced by Bear Stearns and Lehman Brothers were increased by a run on their over-the-counter (OTC) derivatives’ counterparties. The flight of those derivatives’ counterparties, as they sought new positions with other dealers, may also have contributed to the fragility of global financial markets.
In response to this irresponsible trading, the Dodd-Frank Act was passed, which required that OTC derivatives be regulated. The law is still being implemented, but its implementation alone could set off another catastrophic chain of events. One of our favorite bloggers, ZeroHedge, offered this little tidbit for consideration:
Over the next year and a half exchanges need to onboard over $200 trillion notional in various products, and in doing so, counterparties, better known as the G14 (or Group of 14 dealers that dominate derivatives…) will soon need to post billions in initial margin, and as a brand new BIS report indicates, will likely need significant extra cash to be in compliance with regulatory requirements. Not only that, but once trading on an exchange, the G14 “could face a cash shortfall in very volatile markets when daily margins are increased, triggering demands for several billions of dollars to be paid within a day.” Per the BIS “These margin calls could represent as much as 13 percent of a G14 dealer’s current holdings of cash and cash equivalents in the case of interest rate swaps.
So basically, when boiled down to brass tacks, this is what the whole mess means. Banks were irresponsible prior to 2008, and took on more risk [in non regulated, over the counter derivatives] than they could handle, which would end up being their undoing. To prevent such a disaster from happening again, laws have been passed in the U.S. which require most OTC derivatives to be cleared through a central clearinghouse. But this increase in collateral required to execute such trades could very well send some investment banks into a capital squeeze, which would bring the OTC derivatives which rely on those banks as counterparties declining in value, resulting in the banks that hold those losing capital – which would result in the derivatives they are counterparties to losing value… and so on and so on.
Anyone who wants to get into politics or economic policy should review this catch 22 over and over to make sure they are up for the challenge. It’s like we have figured out that these ships (the banks) we all travel on need more lifeboats (as opposed to none pre-2008), but putting more lifeboats on the ships puts them at risk of sinking… What to do…