About a year ago I wrote comments to the Securities, Insurance and Investment Subcommittee of the Senate Banking Committee about the regulation of investment banks after the Bear Stearns collapse … I tried to highlight several principles about financial markets stability and regulation.
The main principle which I tried to focus on is that markets, if operated and regulated in a transparent manner, are inherently self-stabilizing …. this was a counterpoint to the idea that a “super regulator” must be given authority to enforce “systemic stability”…
The idea of self-stabilizing markets is that market participants are free to choose who they trade with and they will make wise economic choices based upon the condition of their counterparties… the closeness of trading and lending relationships allows them to assess how much risk they should take with other entities…
There is a big caveat to this approach… it presupposes that the financial condition or riskiness of counterparties is known with sufficiency to determine counterparty risk … it assumes a high level of transparency…
As the events of the financial crisis/panic of 2007-2009 are examined it will be useful to understand what type of counterparty risk systems the major financial institutions employed. For example in the case of Bear Stearns how did it’s lending and trading partners evaluate their exposure on a day to day basis?
Obviously the spread on Bear’s CDS was used as a proxy for their default risk. But there was likely many other things going on at the time within markets related to information flow about Bear Stearns. Understanding the assumptions and signals of these systems will help us understand if regulators are monitoring the proper information to maintain stability and will also inform our understanding of the uses and value of regulated and private price reporting systems.
I wrote specifically about using transparency to promote market stability in comments in the Wall Street Journal….
~~~~ “The truth is that over-the-counter markets are generally much larger than exchange traded markets… there is no transparency or public price reporting in these markets… these are dealer dominated markets like the credit default swap space… it is these markets including and specifically the CDS and structured finance market (CDO, SIV, ABCP) that have created the current market instability. And the need for enormous bailouts with public funds.
It is sheer folly to imagine that collecting market and trade data for these markets that is shown only to regulators will create stability.
Stability demands transparency through publicly reporting trade data which is shared with all market participants >> pension funds, commercial banks, hedge funds, mutual funds… that is how markets are capable of determining “fair market” or market clearing prices… and how they are stable.
It is unfathomable that these markets could be stable by remaining “dark”… sunlight is critical…
These markets are not “incubator markets” … these markets are the “elephant in the room”… and the elephant is stampeding through our economic system…
The standard for regulation of financial markets must be along transparent lines:
1. Accounting standards should require firms to mark-to-market their assets (continue Levels 1, 2, and 3)
2. Trade data for all OTC products should be aggregated and redistributed to market participants
3. Exchanges and alternative trading systems should disclose trade volumes in total and by security
4. Once a product reaches a certain trade volume it should clear through a central counterparty platform
5. More disclosure of municipal finances
6. Public companies should disclose all outstanding securities, futures and derivatives in quarterly/annual filings
7. Eliminate “rating shoppings” for all classes of fixed income
8. Open source the CUSIP system
Regulators can play a role in ensuring stability in the financial system… but market participants must have sufficient information to evaluate risk and return and the health of institutions with whom they may choose to do business.
Chairman Greenspan said in this recent testimony to Chairman Waxman’s Committee that he always believed that counterparties would police the creditiworthiness of their trading partners… this is a legitimate belief… it is one part of a healthy foundation for the financial system… but transparency is critical for market participants to determine counterparty risk …
I urge Congress to enhance market information for everyone. Engineer stability by open sourcing transparency…”~~~~
The news from Washington about the possible expansion of the TRACE price reporting system to OTC derviatives is very important for creating open, stable markets… I commend the SEC for taking up the extension of transparency to this market…
~~~~ “May 14 (Bloomberg) — U.S. regulators may impose the same price reporting and transparency requirements on over-the-counter derivatives that reduced bank profits by almost half in the corporate bond market when the Trace system was adopted seven years ago.
“I think it’s something we’ll look at very closely as a potential model,” Securities and Exchange Chairwoman Mary Schapiro said yesterday at a news conference in Washington, in which regulators laid out potential structural changes to improve policing of the $684 trillion OTC derivatives market.” ~~~~
The over the counter derivatives markets are very concentrated and risk from the trading books of a handful of these banks pose significant issues for the stability of the global financial system.
Analysis and Discussion with Tim Backshall of Credit Derivatives Research (Bloomberg News…. running time = 5 minutes)
From Reuters: ~~~~ “NEW YORK – The top four derivatives dealers in the United States — units of JPMorgan Chase & Co , Bank of America Corp, Citigroup Inc and Goldman Sachs Group Inc — account for 94 percent of the contracts, according to the Office of the Comptroller of the Currency (OCC).
The Obama administration is looking at increasing supervision of over-the-counter derivatives, which account for the vast majority of outstanding derivatives.
The following is a list of derivatives exposure at the top four largest dealers, as well as total derivatives exposure for commercial banks and trust companies, according to the OCC:
BANK TOTAL DERIVATIVES PCT OF DERIVATIVES – OUTSTANDING ($ MLN) THAT ARE OTC
JPMorgan $87,362,672 mln
Bank of America $38,304,564 mln
Citi $31,887,869 mln
Goldman Sachs $30,229,614 mln
All banks total $200,381,607 96.6 ($193,597,433 mln)
(Source: http://www.occ.treas.gov/ftp/release/2009-34a.pdf)
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