Deregulation of Derivatives Would Be a Bad Mistake
By Randall Dodd
11 August 2000
Vol. 165, No. 154
Copyright (c) 2000 American Banker, Inc. All Rights Reserved
The derivatives deregulation bills that a few members of Congress are
franticly rushing through the legislative process are seriously flawed.
This is a huge market -- the Bank of International Settlements recently
estimated it at $190 trillion worldwide -- but there has been scant
public debate about deregulating it. Arguments for doing so have gone
Public debate is not only essential to democracy on principal, but also
serves the practical purpose of ferreting out policy errors and
Two very similar bills would affect the regulation of derivatives markets.
In the Senate, S 2697, co-sponsored by Sen. Richard Lugar, R-Ind., and
Sen. Phil Gramm, R-Tex., has been reported out of the Agriculture
Committee and awaits action from the Banking Committee.
In the House, Rep. Thomas Ewing, R-Ill., has authored HR 454, and
slightly modified forms of the bill have been reported out of three
committees -- Agriculture, Banking, and Commerce.
All these versions of the legislation would exclude over-the-counter
derivatives from government regulation and radically reduce the level
or surveillance and supervision on futures exchanges.
The proponents of deregulation build their case on three points:
Financial markets are so large that they are not susceptible to manipulation.
There is no price-discovery process in over-the-counter derivatives markets, so there is no public-interest concern.
The OTC derivatives markets are made up of sophisticated investors who
do not need to be protected from fraud and the failure of others.
Let me point out the problems with these premises.
RISK OF MANIPULATION
The world's largest and most liquid market is the one for foreign
exchange. Yet the Quantum Fund hedge fund operated by George Soros is
widely credited -- or blamed -- for moving the market to devalue the
British pound in September 1992.
The market for U.S. Treasury securities, with its $600 billion in daily
trading volume and another $1 trillion in repurchase agreement
transactions, is the world's premier market in terms of efficiency and
sophistication. Yet this market has been the subject of manipulation
several times in recent years:
The prestigious bond trading firm of Salomon Brothers was found to have cornered the bond market in 1992.
In 1996 the investment bank Fenchurch was found to have corned the
10-year note market in order to manipulate the futures market.
Last December the head of the Federal Reserve Bank of New York's bond
trading desk warned about repeated incidents of manipulation in the
markets for repurchase agreement on Treasury securities.
The prices and rates established in OTC derivatives markets are, in
fact, regularly reported as the reference prices and rates for other
markets throughout the economy. Information about rates and spreads in
the interest rate swaps market is critical to those for home mortgages
and corporate bonds.
This leading role is all the more important in light of the possible
demise of the U.S. Treasury securities market as federal government
surpluses continue to shrink that market.
The forward and swap rates on foreign currency are regularly and widely
reported, and they are critical to international trade and cross-border
investments. This is not an incidental part of the OTC derivatives
markets. Interest rate swaps, forward rate agreements, and foreign
exchange forwards and swaps make up 77% of the volume in the OTC
derivatives markets, according the Bank for International Settlements.
The role of these markets in establishing prices used throughout the
economy has long been the basis for regulatory oversight. As the
Commodity Exchange Act states:
"The prices involved in such transactions are generally quoted and
disseminated throughout the United States and in foreign countries as a
basis for determining the prices to the producer and the consumer of
commodities, and the products and byproducts thereof, and to facilitate
the movements thereof in interstate commerce." These markets "are
affected with a national public interest" making it "imperative" that
the federal government take actions to detect and prevent market
manipulation and fraud.
Defining "sophistication" as having substantial wealth is not a good
enough measure. Moreover, requiring that investors be sophisticated is
in practice not enough to assure safety and soundness.
Imagine an investment firm with $5 billion in capital and management
made up by the former head of the top bond trading firm on Wall Street
and a couple of economists who received Nobel prizes for developing
derivative pricing formulas.
This combination of capital, financial market experience, and
intellectual brilliance is at the very highest standard for market
sophistication. Yet these attributes, plus $1 trillion in derivatives,
were the state of Long Term Capital Management.
These sophisticates orchestrated such an enormous failure that they
lost not only 90% of their investors' money but also disrupted market
activity and threatened the solvency of many of the largest financial
institutions. Sophistication is clearly not enough to assure that
derivatives market do not threaten the rest of the economy.
In light of these problems with the premises underlying the
broad-reaching deregulation of derivatives, lawmakers should halt their
frantic rush to cut them loose from regulatory oversight.
Instead they should pursue a deliberate course to determine the appropriate level of regulation.