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Litan on Regulatory Reform of Derivatives

 

Robert E. Litan, a Senior Fellow at The Brookings Institution and Vice President of Research and Policy at The Kauffman Foundation, has authored a paper providing his thoughts on and critiques of some of the regulatory reform efforts aimed at derivative instruments.  In the publication, "The Derivatives Dealers' Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and other Interested Parties," Litan summarizes his paper in his own refreshingly conversational style:

For readers who want the bottom lines right now, I provide them in this initial Executive Summary. In the body of the essay itself that follows I begin by giving readers a brief overview of the basics of derivatives, the institutional characteristics of the markets in which they trade, and both their benefits and risks. I then turn to the major reforms now being considered by the Congress and that regulators have suggested or have been urging to reduce the risks of OTC derivatives. I am uncomfortable, however, with one set of “reforms” that some have urged to reduce systemic risks in derivatives -- a ban or severe restriction on “speculative” purchases of derivatives, “naked CDS” in particular, and outline those concerns in a separate section.

Litan characterizes the goal of reform of regulation of the derivatives markets as making the market safer and more transparent, and containing the following features:

  • Induce or require “standardized” derivatives to be “cleared” on central clearinghouses rather than handled by dealers, acting on behalf of each of the parties (the buyer and seller) to these contracts.[note omitted]

 

  • Establish the conditions that will induce derivatives that are centrally cleared to be traded on exchanges or an equivalent transparent platform, as is now the case generally with stocks and futures contracts.

 

  • Ensure that adequate reserves – in the form of capital or margin – are held against all trades that are not centrally cleared.

 

  • Require the margin or collateral backing derivatives positions to be held either in segregated accounts or by third parties (such as a central clearinghouse) so that these funds cannot be co-mingled with other assets of dealers.

 

  • For derivatives that are both centrally cleared and traded on exchanges, regulators should ensure that the transaction prices and volumes of derivatives transactions are posted promptly on the equivalent of a “ticker” (post-trade transparency), while also ensuring that the prices at which buyers are willing to trade (the “bids”) and sellers willing to sell (the “asks”) are made public so that all parties, not just the dealers, know the state of the market at any given time (pre-trade transparency). I believe that a price ticker, or something close to it, should be in place even without central clearing and/or exchange trading.

Though many of Litan's assertions and recommendations leave much room for debate, his treatment is a very interesting, thought provoking, and v easy to read.  It is a provocative piece worth reading for those interested in what is happening in regulatory reform of derivatives.

The full text of Litan's paper is available at: http://www.brookings.edu/~/media/Files/rc/papers/2010/0407_derivatives_litan/0407_derivatives_litan.pdf