Reforming the Over-the-Counter Derivatives Market: What's to Be Gained?
Cherny, Kent, Craig, Ben R., Economic Commentary (Cleveland)
While derivative financial instruments have made the hedging and exchange of risk more efficient, the recent crisis showed that they also pose a substantial threat to financial stability in times of systemic turmoil. Underlying much of this threat is the lack of transparent reporting in the over-the-counter market for these instruments. This Commentary discusses the advantages of one solution to the transparency problem: moving the settlement or trading of derivatives to exchanges or clearinghouses.
United States legislators are poised to pass comprehensive financial reform legislation. While the final form of the bill is yet to be decided, it is almost certain to contain requirements for broader regulation of derivative instruments.
The financial crisis in 2008 saw the emergency merger of Bear Stearns with J.P. Morgan Chase, the failure of Lehman Brothers, and the near-failure of the insurer American International Group (AIG), all of which were major institutional participants in the derivatives market. Problems at these firms revealed uncertainty about the amount and interconnectedness of derivatives exposure in the financial system, which, in some cases, contributed to the freezing up of markets or forced the Federal Reserve and the federal government to intervene in others.
The events of the recent financial crisis revealed that the current derivatives market framework is not robust enough to withstand a systemic disruption without exacerbating contagion concerns, requiring direct or indirect support from fiscal and monetary authorities, or both.
As we noted in a previous Economic Commentary (July 2009), derivatives are used by financial institutions and corporations to adjust their exposure to particular financial risks, such as the default of a borrower or wild swings in interest rates. Both in theory and practice, these products have made the hedging and exchange of risk in the financial system more efficient. In its current form, however, the derivatives market poses a substantial threat to financial stability in times of systemic turmoil. The lack of transparent reporting of trades and exposures leaves both regulators and investors uninformed about where risks are concentrated within the system. Without this information, regulators cannot monitor banks' exposure to particular risks, and investors cannot use market prices to discipline the unbalanced risk exposures of their peers.
Changing the way the derivatives market operates, particularly by providing market stakeholders with adequate trade and pricing information, would lessen the threat it poses to financial stability without closing off a vital resource for managing risk. One solution to the transparency problem is to move the settlement or trading of derivative instruments onto exchanges or clearinghouses. These frameworks- already successfully employed in other, more familiar markets such as those for stocks and options- allow for easier dissemination of market information as well as institutional oversight by government regulators, investors, and clearing entities.
Derivatives Markets: Useful, but Not (Yet) Robust
It is worth reiterating the purpose that derivatives serve in the financial system: They allow specific risks to be shed or acquired without the purchase or sale of an asset. This may not sound profoundly important in abstract terms, but a practical example can clarify their usefulness, as well as outline the current structure of the market. Suppose a bank is approached by a software company looking to take out a $5 million loan, and after a thorough review of the company's financial condition, the bank underwriters determine that the loan would be a safe and profitable investment. However, the bank's risk manager informs the underwriters that the bank already has a lot of exposure to the software industry, and that making the loan would weight the lending portfolio too much in one direction. …