WASHINGTON (Reuters) - Derivatives industry veterans say efforts by regulators to overhaul the market to make it more transparent could backfire if any changes make these products too standardized and less flexible.
As regulators and politicians wade through a mess brought on by loose lending that helped create the worst housing slump in decades, industry experts fear radical change to the way derivatives are traded is in the offing as well.
Yet, had many of the safeguards now in place in the sophisticated $62 trillion credit default swaps market been used in traditional bond issues and mortgage lending, things might not have been so bad, experts say.
“If you forced standardization, then you are limited in the range of things you could do in terms of transferring risks,” said Darrell Duffie, professor and derivatives expert at Stanford University. “It will slow down innovation.”
Fears are running high after regulators and politicians have stepped in to shore up housing finance giants Fannie Mae FNM.N and Freddie Mac FRE.N with plans that could call for the government to buy an equity stake using taxpayer funds.
The latest emergency action came months after the Federal Reserve engineered and took on some of the risk in a buyout of the investment bank Bear Stearns, which almost collapsed in March after it made wrong bets on mortgage-backed securities.
There are growing fears that the U.S. government’s role in these regulated businesses has been to let profit-making firms operate in a framework where their risks will be
nationalized — all at the taxpayers’ expense.
“Since the credit crisis beginning in July 2007, the credit derivatives indices have provided greater liquidity, depth and electronic execution than traditional loans and corporate bonds,” said Sunil Hirani, chairman and chief executive of Creditex, an electronic credit default swaps platform.
Swaps participants say they have strong incentives on their own to address any weaknesses they identify.
“Since the Bear Stearns affair, market participants and regulators are acutely aware of counterparty credit risk and there are numerous initiatives,” Hirani said.
But regulators are still looking for changes.
At congressional hearings last week, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox all told lawmakers that how these instruments are structured, traded, tracked and accounted for needs to be standardized.
“We have too much complexity, not enough standardization,” Paulson told the Senate Banking Committee.
Cox said to that same panel: “The objective is to move our infrastructure in a direction where there’s more standardization, more central counterpart activity, cleaner resolution in the case of a problem, and better transparency.”
Federal Reserve Bank of New York President Timothy Geithner is expected to echo those concerns when he appears later this week before the House Financial Services Committee. He is working with major swaps dealers to help develop a clearinghouse.
But little progress has been made on that plan, which may get caught up in a spate of regulatory and operating hurdles, market sources close to the clearing project have said. And even with a central clearinghouse, there are risks — specifically, concentration and “moral hazard” risks.
“If it is deemed under the wing of the Federal Reserve, then it is a moral hazard,” said Peter Wallison, an expert in financial deregulation for American Enterprise Institute, who also worked for the Treasury Department in the Reagan administration.
The central clearinghouse is likely to not ever get off the ground because of these issues.
Making trades in this market more standardized could have some advantages: Trades could be easier to track, easier to price and easier to unwind or reconcile with other holdings.
But industry experts say there are systems now that do that and also allow for tailored transactions.
“Too much standardization is not a good thing,” warned Duffie, who noted there are many advantages to a clearinghouse.
One International Swaps and Derivatives Association plan, to be running by the end of this month with 13 dealers participating through the Creditex and Markit systems, will help compress and reconcile credit default swaps portfolios.
“Standardization has to proceed cautiously so that innovation remains the hallmark of this industry,” said Robert Pickel, chief executive of ISDA.
But now regulators want to reshape how financial markets operate and shine more light into the opaque credit default swaps industry.
“The more standardized it is, the more transparent it can be,” said Robert Mackay, senior vice president at NERA Consulting, who worked at the Commodity Futures Trading Commission and also served on the President’s Working Group for Financial Markets. “There is cost if you force things to be standardized because then you lose the customized product that really does the job,” Mackay said.
And bringing older techniques like standardization, used in the securities and futures industries, to the OTC markets misses the point.
“In the past 10 years, technology has advanced so that we can process customized trades, manage their risks, and even make them transparent. Standardizing would be a step back,” said Mark Brickell, CEO of the electronic swaps trading platform Blackbird Holdings, Inc.
One regulator, namely the Office of the Comptroller of the Currency, the top regulator of the key derivatives dealers, has not endorsed any industry group’s proposal.
“We’re not advocating any particular solution, but rather wanting to see these risks reduced,” said Kathyrn Dick, deputy comptroller for credit and market risk. “Historically what we’ve found is there’s usually a couple of different solutions to these problems.
“As regulators, we are going to be looking for certain protections,” she added.
Reporting by Joanne Morrison; Editing by Jan Paschal