Tuesday, 1 December 2009

Regulating derivatives markets

There are signs that the extremely well-organised US banking lobby is successful in killing attempts to introduce more regulation of the derivatives markets. The US regulators have presented a project to force substantial part of the OTC (over the counter) market into becoming a transparent, regulated market.

The advantages of doing this are obvious: By creating a clearing house, the market will roughly know who is exposed as counterparts. By using standard contracts, it will be possible to create a reasonably efficient second market, where buyers of the products will be able to sell their derivatives at a narrow bid-offer spread.

Previous moves in this direction have always seen a positive effect for nearly everyone: Better liquidity, lower prices, improved regulatory oversight. All of those things would have very nice to have during the big bailouts of US banks last spring. So it is not surprising that the suggestions presented by the chairman of the US Commodities and Futures Trading Commission contain exactly these provisions.

Intense footwork from the bank lobby has been efficient. Several major US manufacturing companies have come out in favour of individual, non-standard contracts, citing that it will be cheaper and more efficient to work on the basis of individual contracts. They have even gone so far as to say that if they cannot continue having their individual contracts, it may cost jobs. And these jobs may magically disappear in the constituencies of certain senators or representatives.

Here as in many other contexts, it is about money. Contrary to what the OTC providers claim, they make more money on individualised contracts than on standard contracts, and the big players maintain a huge advantage by knowing more about the flows than other market participants.

The best guess is that the US banking lobby has already managed to kill off the attempt at regulation, thereby protecting the revenue of the big players in the OTC market. A year ago the banks needed rescue. Now they have been rescued, and promptly use some of the money they received to block relevant legislation.

In Europe there has been some hesitation on the part of the EU regulators, there has been a hearing but obviously EU regulators wanted to delay their own proposal until they had indications regarding the US initiatives. Now it will be exciting to see if the EU regulators have the guts to present new regulation in the absence of US initiatives.

Initially one would expect this NOT to happen. However, in this particular case there would be good reasons to do so. Previous experience with regulated and standardised derivatives markets have been encouraging. Loads of players have moved over to the standardised markets and have realised that they were more efficient. The experience of the European markets in bond futures are a good example. So actually here might be a way of attracting turnover by being stricter. It does not happen often, but in this case it appears so obvious that it would work.

Another example where it would be good to see European leadership.

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