Over the counter, out of sight - The Economist

IN 1958 American onion farmers, blaming speculators for the volatility of their crops’ prices, lobbied a congressman from Michigan named Gerald Ford to ban trading in onion futures. Supported by the president-to-be, they got their way. Onion futures have been prohibited ever since.

Futures are agreements to trade something at a set price at a given date. They are perhaps the simplest example of a derivative, a contract whose value is “derived” from the price of a commodity or another asset. Derivatives continue to be vilified, usually when someone loses a lot of money. Orange County and Procter & Gamble lost fortunes on them in the 1990s. They were at the core of Enron’s failure. And in September 2008 they brought American International Group (AIG), a mighty insurer, to its knees. Its fetish for credit default swaps (CDSs), a type of derivative that insures lenders against borrowers’ going bust, led it to guarantee at least $400 billion-worth of other companies’ loans—including those of Lehman Brothers. The American government forked out $180 billion to save AIG from collapse.

Every catastrophe brings calls for restrictions on derivatives. This year Joseph Stiglitz, a Nobel economics laureate, has said that their use by the world’s largest banks should be outlawed. But derivatives have defenders too. Used carefully, they are an excellent—some would say indispensable—tool of risk-management. Myron Scholes, another Nobel prize-winner, says a ban would be a “Luddite response that takes financial markets back decades.”

Because of the mayhem of the past year or so, lawmakers in America and Europe are on the point of giving derivatives markets their biggest shake-up since the 1970s. For the world’s biggest banks, billions of dollars are at stake. For taxpayers, the stakes are just as high.

Derivatives come in many shapes. Besides futures, there are options (the right, but not the obligation, to buy or sell at a given price), forwards (cousins of futures, not traded on exchanges) and swaps (exchanging one lot of obligations for another, such as variable for fixed interest payments). They can be based on pretty much anything, as long as two parties are willing to trade risks and can agree on a price: commodities, currencies, shares or bonds. Derivatives create leverage too. Contracts are sealed with initial payments that are a small fraction of the potential gain or loss.

In the main, businesses use derivatives to shift risks to other firms, chiefly banks, that are willing to bear them. An airline worried about fuel prices can limit or fix its bills. A bank concerned about its credit exposure to the airline can pass some of its default risk to other banks without selling the underlying loans. About 95% of the world’s 500 biggest companies use derivatives. A lack of them can be costly. “The absence of derivatives in iron-ore markets makes negotiations between Australian suppliers and Chinese buyers very confrontational,” says Philip Killicoat of Credit Suisse. Earlier this year Rio Tinto’s chief negotiator, Stern Hu, was arrested in China during hard bargaining over prices. And the futures ban has not stopped the price of onions from going up and down.

Derivatives have a long history, stretching back thousands of years. In the 17th century the Japanese traded simple rice futures in Osaka and the Dutch bought and sold derivatives in Amsterdam. But trading in financial derivatives really took off only in the 1970s. The fluctuations in currencies and interest rates after the collapse of the Bretton Woods system gave a push to demand. The option-pricing formula developed by Fischer Black and Mr Scholes, plus advances in computing power, made valuing derivatives much easier. Regulators encouraged them, too. Thrift Bulletin 13, issued by the Federal Home Loan Bank System in 1989, obliged American thrifts to hedge their interest-rate risk.

Derivatives are bought and sold in two ways. Contracts with standardised terms are traded on exchanges. Tailored varieties are bought “over the counter” (OTC) from big “dealer” banks. These banks support the OTC market by hedging their clients’ risks with each other or on an exchange.

The OTC market dwarfs exchange trading (see chart 1). Estimating its size, however, demands caution. In figures published this week the Bank for International Settlements, the central bankers’ central bank, puts its “notional” value at $604.6 trillion. But “those numbers don’t appear on anyone’s balance sheet,” says Barry Epstein, an accountant who specialises in derivatives. For example, the notional value of the CDS market is $36 trillion, says the BIS. But that counts all guaranteed debt—the equivalent, in home insurance, of the value of houses covered rather than premiums paid.

For interest-rate contracts, notional values are even more misleading because they are based on principal amounts; actual obligations depend on interest payments. “Gross market values”, which show how much money would change hands if derivative contracts were sold on the reporting date at prevailing prices, are a better guide. But even they are an overstatement. Once banks’ claims on each other are stripped out, the residual (“gross credit exposure”) is $3.7 trillion, well under 1% of the notional total (see chart 2).

Even so, $3.7 trillion is a large sum. And although derivatives did not cause the financial crisis, they (or their misuse) made it worse. They concentrated risk as much as they spread it, and amplified bad judgments. Their leverage magnified losses on underlying assets like mortgages and crippled even the biggest firms.

Size is not the only reason for regulators’ interest. Another is a practice called “close-out netting”. Traders of OTC derivatives record their net obligations to each other. On any day, each trader’s thousands of bilateral contracts boil down to a single net position owed to or by its counterparties. Netting agreements ensure that if a trader goes bankrupt its position is settled at once, with no need to wait for a court.

“Counterparties to derivative contracts effectively get a super-senior claim to each other’s assets,” says Craig Pirrong, a finance professor at the University of Houston. For example, in 2008 Goldman Sachs extended credit to CIT, a troubled American lender, but in the form of a “total return swap”, a type of derivative, rather than a conventional loan. Now that CIT has filed for bankruptcy, close-out netting puts Goldman up the queue for repayment.

Another problem is that governments implicitly subsidise derivative markets. Dealer banks are so important to the financial system that they cannot be allowed to fail. This government guarantee lowers their cost of borrowing and allows them to provide derivatives more cheaply than they otherwise could. “Even if dealers keep much of the benefit for themselves, everyone is getting derivatives more cheaply at the expense of the taxpayer,” says Edward Kane, a professor of finance at Boston College. About one-third of OTC trades require no margin or collateral requirements at all. In effect, firms can get leverage for nothing. On exchanges, traders must put up margin or collateral.

Complexity is a further worry. Richard Bookstaber, who headed market-risk management at Morgan Stanley, says that “complexity cloaks catastrophe”. Clients—even supposedly sophisticated ones—do not always understand the risks they are taking on. That’s their lookout, you might say, so long as traders do not defraud them and so long as bankrupted clients do not have to be bailed out by the state.

But regulators do have an interest in complexity. It makes valuation difficult: dealers often allocate different values to the same contract. This in turn makes financial accounts more opaque. (Remember Enron.) And the popularity of arcane derivatives has been sustained by “less than lofty purposes”, says Mr Bookstaber. For example, under the Basel capital-adequacy rules, when a bank makes a loan to an ordinary company it has to set aside 8% of the loan’s value as capital. But for loans to other banks the charge is only 1.6%, because the rules assume banks are more creditworthy. The less they must put aside, the more banks can lend and the more money they can make. This is where CDSs come in handy. A bank overexposed to airlines can use CDSs to share credit risk with other banks and slash the cost of holding the loan. Buying a CDS from AIG, which had a high credit rating, gave banks a similar deal. No wonder they were so eager.

Time to clear up

Regulators have a two-part answer to these problems. First, they want more OTC contracts to be cleared by central counterparties (CCPs). A central banker in Europe thinks this will offer “a clear point of entry for authorities to rescue the financial system next time, rather than rummaging through a mire of interlocking obligations.” Second, they want more of them to be shifted to exchanges.

The American Treasury has made specific proposals. The European Commission is a couple of steps behind, but promises to “ensure global consistency”. To prod derivative markets towards clearing, and ideally trading on exchanges, OTC trades that are not cleared will face a higher capital charge than contracts that are. This may ruin the habitat of more exotic OTC species. Regulators think this is a cost society can bear.

In America supervision would remain split between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC would regulate derivatives tied to individual securities and the CFTC much of the rest. For instance, the SEC would oversee CDSs for a single company, whereas the CFTC would regulate those for an index with more than ten names.

CCPs have been around since 1925, when the Chicago Board of Trade Clearing Corporation became the legal counterparty to buyers and sellers of derivative contracts. CCPs take margin and collateral according to the size of trades, so that if a trader defaults, the clearing house should see his counterparty right. They also allow traders to net their positions across all their counterparties, reducing the margin and collateral required.

A sizeable proportion of CCPs are likely to be owned by banks, even though a cap of 20% on their stakes is being mooted in Congress. This year at least three new CCPs have been given approval to clear credit derivatives. Two of them failed to attract significant volume. The other, ICE Trust, is backed by leading dealer banks. In October LCH. Clearnet, an established clearing house, underwent a €330m ($489m) share buyback that happened to boost banks’ shareholdings.

To calculate margins, CCPs need to compute a derivative contract’s volatility, but for a lot of customised OTC contracts the necessary historical price data do not exist. So the proposed rules require only that “standardised” derivatives be cleared. Clearing CDSs presents another difficulty: because a firm is either bankrupt or not, it is difficult for CCPs to demand margins or collateral that vary smoothly with the risk of the loans insured. The world’s largest banks have promised the Federal Reserve they will clear more than 90% of “eligible” interest-rate and credit derivatives by the end of the year. But this includes only derivatives now accepted for clearing.

Deciding what else should be cleared will be fraught. Some argue that regulators should choose, others that CCPs themselves should: if they can clear it, then it must be cleared. Different CCPs may have different motives. Independent clearing houses may overreach themselves in the hope of scooping up more business. CCPs owned by dealer banks might be more reluctant to clear because their owners might find it more profitable to keep trades purely two-way and charge bespoke prices.

CCPs are lauded for their safety and efficiency. When Lehman Brothers defaulted, LCH.Clearnet, the largest clearer of interest-rate swaps, processed its $9 trillion of OTC interest-rate derivatives seamlessly. Even so, regulators may be creating another set of institutions that are too important to fail. CCPs are supposed to have enough money in hand to withstand the default of one member under “extreme but plausible” conditions—whatever that means. As Ben Bernanke, the Fed’s chairman, has noted, CCPs’ margin and collateral will never be enough to protect them from a financial earthquake. Taxpayers will have to back them.

Exchange of views

Reforms will accelerate a shift to CCP clearing that was already under way, but proposals to push standardised and cleared derivatives onto exchanges are new, and more contentious. Critics believe large dealers “have a strong incentive to steer clients towards complex OTC rather than exchange-traded derivatives, because the margins are so much greater,” says Frank Partnoy, a professor of law and finance at the University of San Diego.

Indeed, commercial banks in America have pocketed $115 billion from cash and derivatives trading in the past ten years, according to the Office of the Comptroller of the Currency, a regulator. “Banks lump their trading revenue together but the significant majority of it comes from derivatives,” says Kevin McPartland of TABB Group, a research firm. The market is concentrated, too. In America the leading five dealer banks account for about 95% of all banks’ derivative contracts by value. This year trading has been especially lucrative. In the first six months of 2009 American banks earned $15 billion (see chart 3). Market insiders at an inter-dealer broker believe that derivative revenues at the biggest European banks are at least as large.

Robert Pickel, chief executive of the International Swaps and Derivatives Association, a trade group, dismisses accusations of profiteering. He says that users can always phone different dealers to get the best price. And dealer banks are rewarded for risks they assume.

Even so, exchanges would eat into banks’ trading profitability by making prices more widely available to buyers of OTC derivatives. But getting OTC derivative markets to use trading platforms is harder than getting them to clear: anything traded on an exchange can be cleared, but the converse is not true.

A simple OTC contract with an obscure maturity date is easy to value and margin. But it would not elicit enough interest from buyers or sellers to justify listing on an exchange. And OTC derivative trades are usually big. On an exchange, a single order could move the market price, creating uncertainty for traders. Mr McPartland likens this to buying a book on Amazon instead of eBay: you often pay more at Amazon, but at least you know the price in advance.

Regulators will permit use of a “swap execution facility” in place of an exchange. But that term remains undefined. It could mean simply allowing broking over the telephone to continue. Or it could mean an electronic trading system provided by a third party. ICAP, the biggest inter-dealer broker, has two such platforms ready to go.

Watchdogs are also expected to establish data repositories, which will give them unfettered access to dealers’ trades. BME, the Spanish stock exchange, launched a new one this month. These should alleviate uncertainty about inter-bank exposures. But Darrell Duffie, a finance professor at Stanford University, worries the reforms will not go far enough. “Any derivatives that are cleared should have the prices made public, regardless of whether they are put through an exchange,” he says.

Non-financial firms that use derivatives are keen to escape the new rules. They have no wish to be forced into joining a clearing house and thus into more demanding margin calls. Nor do they like the idea of capital charges. More than 170 of these “end users” wrote to Congress last month arguing that they needed derivatives but would not be able to afford them under the new rules. So far the proposals leave them out. But Mr Duffie asks: “What sort of firm is General Electric?” (it has a big financial division). Regulators fear that hedge funds, which are not strictly financial institutions, will wriggle out, too.

Some argue that those who use derivatives should face the economic cost whatever their legal status. Easier standards for end-users could encourage them to trade even more. Mr Partnoy thinks they are already predisposed to trade too much: “Making $10m profit here and there irresistibly snowballs into a bigger trading operation.” Their risk-management, he adds, is not as savvy. Josh Rosner, managing director of Graham Fisher, a financial-research firm, says banks will game the rules: “Dealers like Goldman Sachs could reach agreements with exempted firms like Cargill [a food trader] and funnel their derivative trades through them.”

Some companies are acting already. Paul Chrispin of Principal Search, a recruitment firm, reckons that physical trading firms like Noble and Vitol have been on a recruitment drive among banks’ derivative traders. “Traders are worried about their future compensation at banks; and the freer regulatory environment at non-financials makes them an attractive place to work right now,” he observes.

The ingenuity of derivatives traders in adapting to both market forces and regulations may well send supervisors back to the drawing board in a decade or so. For now, a higher capital charge for OTC contracts is a sensible step. Doing away with derivatives altogether is neither wise nor likely. As Mr Scholes says: “Cars cause accidents but we don’t ban them.” But the state does insist on seat belts.

De