Meaningful Derivatives Reform....FAT CHANCE!

[DrDoom]

Another argument to break up the Big 5!

Bob Litan of the Brookings Institute has a new paper out on derivatives reform (full pdf, summary). The paper is called “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties” and it’s a must read for two very important reasons.

Before we get there, I agree with his recommendations for regulating the over-the-counter derivatives market and especially the credit default swap market (CDS): create a strong presumption for over-the-counter derivatives to go through clearing, and to be traded on an exchange with pre-trade price transparency. Those that can’t should have margins posted and have post-trade price and volume transparency. This will be a major battle ground in the financial reform debate, and learning these terms will put you in a better spot to follow it. Litan walks you through each of the terms.

As his title states, Litan is worried about the “Dealer’s Club” of the major derivatives players. I particularly like this paper as the best introduction to the current oligarchy that takes place in the very profitable over-the-counter derivatives trading market and credit default swap market. I’m going to just give the high level overview of what he says (italics in original, my bold):

I have written this essay primarily to call attention to the main impediments to meaningful
reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks…I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being
widely discussed are adopted — that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned…

Here, of course, I refer to the major derivatives dealers – the top 5 dealer-banks that control virtually all of the dealer-to-dealer trades in CDS, together with a few others that participate with the top 5 in other institutions important to the derivatives market. Collectively, these institutions have the ability and incentive, if not counteracted by policy intervention, to delay, distort or impede clearing, exchange trading and transparency…

Market-makers make the most profit, however, as long as they can operate as much in the dark as is possible – so that customers don’t know the true going prices, only the dealers do. This opacity allows the dealers to keep spreads high…

In combination, these various market institutions – relating to standardization, clearing and pricing – have incentives not to rock the boat, and not to accelerate the kinds of changes that would make the derivatives market safer and more transparent. The common element among all of these institutions is strong participation, if not significant ownership, by the major dealers.

Bob Litan on Derivatives Reform 1: Failure even with a Win? Rortybomb

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