The third anniversary of the Lehman debacle continues to weigh heavily on the tag team of Merkel and Sarkozy as they try to block a Greek tragedy titled, ‘Contagion’ from closing the curtain on the Euro.
Amidst that country’s ever-growing sovereign debt crisis surfaced a now-familiar character in our global financial thriller-cum horror story—derivatives. Remember them, the ones Warren Buffett so famously derided as financial weapons of mass destruction?
While regulators on both sides of the Atlantic got a handle on who held Greek bonds, they also scrambled to figure out who was on the receiving end of some $80 billion of derivatives insuring those same bonds. Concern was rightfully focused on whether any of that default risk was concentrated with weak financial players, which could ignite a replay of 2008’s viral market contagion.
Joe Public, me included, assumed that the opaqueness of this market would have been dealt with by now. Not so fast, say the financial lobbyists who have stalled implementation of the Dodd-Frank regulatory framework.
By recent counts, it’s business as usual. The Bank for International Settlements (BIS) reportsa $601 trillion global tally as of YE 2010, up from $586 trillion in 2007, at the outset of the global economic crisis. This is almost ten times the size of global GDP, indicating that the market continues to be dominated by massive stacks of ‘naked’ bets on a smaller underlying asset base. Banks writing these bets argue they provide a valuable risk management tool for the market, while conveniently, also lining their income statements with much-needed fee income. Remuneration aside, most will accept that this market has come to be the most efficient transportation system to distribute risk ever created by man. Think of it as an autobahn of risk, with seat-belts at drivers' discretion.
And on this risk autobahn, what would normally be a small risk event, say a single borrower default (Lehman, for example), can have an impact across a much larger swath of the market. As 2008 showed us, a single collision can quickly turn into a life-threatening, multi-car pile-up on our risk autobahn. This explains why regulators want to install traffic lights and enforce seat-belts; i.e. push the derivatives business onto ‘well-lit’ centralized exchanges and require more collateral on trades.
There’s no better place for the regulatory fever to start than in the U.S., the innovative market which gave birth to these instruments. Our Treasury Department’s most recent reporton U.S. banks’ derivatives holdings through June 30, 2011, discloses a total of $249 trillion, with a troubling top-heavy exposure. Much like 2008, just five banks account for a whopping 96% of all U.S. derivatives. On a risk exposure basis, that’s 241% of their capital, with Goldman leading the pack at 788%! Game of concentration risk, anyone?
So, is there a fix for all this speeding on our derivatives risk-autobahn? Dodd-Frank created the outline, but the devil’s in the details, which was left to a myriad of federal agencies to negotiate by this summer. Specifically on derivatives, Dodd-Frank seeks to move them largely onto centralized exchanges – and pull them out of those five ‘too big to fail’ institutions.
That’s positive, except that in a recent working paper, the IMFargues there are several pratfalls with this singular approach. They point out that today, derivatives are under-collateralized to the tune of about $2 trillion. Collateral of cash or real assets helps to guarantee a counterparty’s performance on their side of a derivatives contract – it’s what any trading business needs to transact with confidence. Sovereigns, AAA-rated companies and ‘Berkshire-Hathaway’ type of entities are not always required to post collateral for their trades, so shifting this business to the light of day of centralized exchanges will probably require an uptick in collateral. That’s a real economic cost that the parties involved, particularly the top banks, may fight tooth and nail to avoid, even leading them to consider moving that business to friendlier foreign jurisdictions. In fact, there are already rumblings that the US and Europe may end up with different frameworks for these instruments.
Regulatory arbitrage, anyone?
The IMF paper goes further to suggest that if negotiations on the Dodd-Frank fine-print do result in a massive shift of these derivatives onto exchanges, then the law will have succeeded in creating new ‘too big to fail’ institutions – the centralized exchanges themselves. All of which raises a new question: who will be the lender of last resort for these exchanges? My money's on our already burdened U.S. Treasury, or more exactly, the U.S. taxpayer. Add that to your monthly grocery bill, Joe Public.
With the third anniversary of the Lehman debacle just past, we should stop and use this moment for a sensible, crisis-free, discussion between government regulators and derivatives dealers, to avoid future, potentially costly, uncertainty in our derivatives markets. Too much regulation will push the creativity of this market (and importantly, its revenues and jobs) to other sunnier shores, whereas not enough of it could leave us exposed to another market crisis — and the second time could be far uglier.
We need to allow the ingenuity of our financial markets to play its part in a sustained recovery, just as much as we need regulators to enforce greater transparency so that we’re not left constantly wondering when and where the next shoe will drop. So yes, allow this business to continue managed by a few top players, but those that chose to maintain that status quo, and benefit by it, should be required to pay a greater share of collateral to keep those pesky risk gods at bay for the benefit of us all. All it would take would be a charge of 1/3 of one percent on all this profitable business to get us to that $2 trillion desired collateral threshold. With those safety bumpers in place, speeding could continue on the risk autobahn.
H.T. Narea is an international banker and lecturer on international finance at Georgetown University’s Graduate School of Foreign Service. Following the path of his father-in-law, Paul Erdman, the former economist, author and MarketWatch.com columnist, Narea has written his first political-financial thriller, "The Fund," published by Forge/Macmillan. Narea’s international plot involves the use of derivatives as weapons of mass destruction. For more info, please visit: http://htnarea.com/