Sunday, November 30, 2008

My "non-testimony" on the regulation of swaps and derivatives

I was recently asked to testify in a Senate hearing "to explore the role of financial derivatives in the current financial crisis, the current system for regulating them and recommendations for modifying the regulatory system".

This hearing was by the Committee on Agriculture, Nutrition, and Forestry, chaired by Senator Harkin of Iowa. That might seem like an unusual place to deal with the regulation of esoteric financial products, but this committee has oversight for the CFTC, because the first futures contracts were agricultural, and the CFTC has oversight on swaps and derivatives, because they have characteristics similar to futures.

I was not able to accept the invitation to testify at the hearing, but it was still worth it, because in his letter, Senator Harkin explained that "You were strongly recommended for your knowledge and insights on this subject by Warren Buffett in a conversation I had with him yesterday". That alone makes the letter worth framing. But although I could not testify, I exercised my first-amendment right to send along off-the-record comments (you can do it too). I will give excerpts from these comments here:

In academic theory, derivatives and swaps are intended to help "span the state space"; that is, they are intended to allow investors to efficiently hedge their specific risks, to more precisely meet contingencies of the market, and to mold their returns to meet investment objectives.

In practice, however, swaps and derivatives are often used for less lofty purposes. They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.

The more complex swaps and derivatives not only find ready demand by serving these functions, there are strong profit incentives for the investment banks to supply them. The more complex the instrument, the greater the chance the investment bank can price it to make profit, for the simple reason that investors will not be able to readily determine its fair value. And if they create a product that is exclusive to them, they can also charge a higher spread when an investor wants to trade out of it.

Viewed in an uncharitable light, derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market. But unlike the more common modes of gambling, these side bets can pose risks that extend beyond losses to the person making the bet. There are a number of ways the swaps and derivatives end up affecting the market:


Those who create these products need to hedge in the market, so their creation leads to a direct affect on the market.

Those who buy these instruments have other market exposures, so that if they are adversely affected by the swaps or derivatives, they might be forced to liquidate other positions, thereby transmitting a dislocation into other markets.

The value of some derivatives can have real effects for a company. For example, the credit default swaps are used as the basis for triggering debt covenants, so if the swap spread rises above a critical level, it can have an adverse effect on the company.

The use of derivatives and swaps can pull capital away from other productive uses. Because these are side bets, capital employed in these markets does not find an end-user.

Those who are writing the derivatives are in effect providing insurance to the buyers, but without any regulatory requirements. Often those writing these instruments are not in a well-capitalized position to pay out in the event that the option goes into the money.


In terms of regulation, here are some points to consider:

The regulators must know who owes what to whom in these markets. Right now there is no way to ascertain the effect on the swap and derivatives markets of a firm failing, because regulators do not know the web of counterparties to these instruments.

We should consider standardization of instruments and make the instruments simpler. As I point out in my book, complexity of financial instruments is one of the sources of market crisis.

We should consider having swaps and derivatives move as much as possible away from party-to-party into a clearing house. This would improve monitoring and provide for a lower risk of default.

There should be stronger oversight on the use of these instruments. Who is buying and selling them,and for what purpose. Perhaps require participants to specify if the instrument is being used for speculation or hedging. Regulators should also ascertain if the use is reasonable; are these instruments simply being used to move risk off-balance sheet or to take on positions that would have been prohibited if they were executed in another way.


[I have added responses to some of the comments]