The Path to Doing Nothing is Paved with Talking about your Good Intentions

First, I realize that this blog post could just as easily be an email to Lion (maybe a twitter at Elias too, I'm not sure). But I can't really pick up girls as an email writer. No, "blogger" is much more to my liking.

But also, I'd like to provide this whole enterprise with a bit of momentum so that when the missing 50% of our writing staff returns from Italy, there will be many new posts to meet them and, it is my most sincere of hopes, to incite them into writing something too.

But also, this is pretty interesting. So here we go.

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.

Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives. (source: CR)

Go ahead and replace "today" with "a few days ago, but Ben was too lazy to write anything about it then" and, as far as I know, the information is still pretty much up to date.

I don't actually have much to add to this. But then again neither did the Treasury. The proposal, the entirety of which you can find at the other end of the link above, is more a statement of purpose than anything. In it, the Obama administration signals to everyone that, "yes, we see what a mess unregulated derivatives (okay, fine, we're talking about credit default swaps) made of everything and, yes, we intend to do something about it."

Is this good news? Well, it's certainly better than no news, but obviously the proof is going to be in the regulatory pudding.

Here are some not very detailed details:

* The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP):

o CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.

o For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

[...]

* All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:

+ Conservative capital requirements
+ Business conduct standards
+ Reporting requirements
+ Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts

[...]

* Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:

+ Recordkeeping and reporting requirements (including audit trails).
+ Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
# CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
# CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators.
+ The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
+ The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
+ The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives. (source: BB)

Since we're talking about credit default swaps, and we are talking about credit default swaps, this all brings to mind a question. Sure we can regulate the hell out this infamous instrument, but is there any reason we really need to have them around (in their current form) in the first place? Taking out insurance on a bond seems to me a legitimate and noble enough pursuit, but what is the rationale for allowing people to purchase CDS coverage on bonds and loans in which they have no vested interest? In the history of insurance law, it only took a few sabotaged merchant ships for people to figure out that allowing individuals to hold shipping insurance on boats or merchandise that they don't own produces all kind of preverse incentives. As far as I can tell, the rationale is the tired old liquidity arguement: by allowing anyone at any time to take out CDS coverage on any bond at any time, you are increasing the overall liquidity of the market. But since when is liquidity in every form such a good thing? This is gambling. If people want to call credit default swaps insurance, lets regulate it as such. I've already posted on this issue back in January (yeah, I'm linking to myself! you want to fight about it?!), but I really don't understand the regulatory pussy-footing around this issue.

But again, this is better than no news.

For further, and not directly related reading, I have two more links:

• A blog post (Zero Hedge via Naked Capitalism) on how AIGs unwinding of its CDS contracts (with the help of the U.S. government) has contributed to the Q1 greenshoots in the banking sector.
• A Planet Money article on the bizzare and now hilariously anarchronistic bureacratic structure of derivative regulation.