By Cliff Montgomery – Jan. 27th, 2010
America’s economy has greatly suffered, in large part thanks to risky Wall Street speculation on future trends in volatile commodity prices, interest rates, foreign currencies and a wide range of other variables.
These gambles are known as derivatives.
The Congressional Research Service (CRS) issued a report to Congress on this matter in December, 2009. It was entitled, Key Issues In Derivatives Reform.
The easy-to-read, highly informative CRS study explained the derivatives meltdown in reasonably simple language, and discussed the reform legislation now before Congress.
It is a must-read for those who wish to know what happened to bring on the Great Recession–and who is responsible for the whole mess.
“Financial derivatives allow users to manage or hedge certain business risks that arise from volatile commodity prices, interest rates, foreign currencies, and a wide range of other variables.
“Derivatives also permit potentially risky speculation on future trends in those rates and prices. Derivatives markets are very large—measured in the hundreds of trillions of dollars—and they grew rapidly in the years before the recent financial crisis. The events of the crisis have sparked calls for fundamental reform.
“Derivatives are traded in two kinds of markets: on regulated exchanges and in an unregulated over-the-counter (OTC) market. During the crisis, the web of risk exposures arising from OTC derivatives contracts complicated the potential failures of major market participants like Bear Stearns, Lehman Brothers, and AIG.
“In deciding whether to provide federal support, regulators had to consider not only the direct impact of those firms failing, but also the effect of any failure on their derivatives counter-parties.
“Because OTC derivatives are unregulated, little information was available about the extent and distribution of possible derivatives-related losses.
“The OTC market is dominated by a few dozen large financial institutions who act as dealers.
“Before the crisis, the OTC dealer system was viewed as robust, and as a means for dispersing risk throughout the financial system. [But] the idea that OTC derivatives tend to promote financial stability has been challenged by the crisis, as many of the major dealers required infusions of capital from the government.
“Derivatives reform legislation before Congress would require the OTC market to adopt some of the practices of the regulated exchange markets, which were able to cope with financial volatility in 2008 without government aid.
“A central theme of derivatives reform is requiring OTC contracts to be cleared by a central counter-party, or derivatives clearing organization. Clearinghouses remove the credit risk inherent in bilateral OTC contracts by guaranteeing payment on both sides of derivatives contracts. They impose initial margin (or collateral) requirements to cover [initial] potential losses… They further impose variation margin to cover any additional ongoing potential losses.
“The purpose of posting margin is to prevent a build-up of uncovered risk exposures like AIG’s. Proponents of clearing argue that if AIG had had to post initial margin and variation margin on its trades in credit default swaps, it would likely have run out of money before its position became a systemic threat that resulted in costly government intervention.
“Benefits of mandatory clearing include greater market transparency, as the clearinghouse monitors, records and usually confirms trades. Clearing may reduce systemic risk, by mitigating the possibility of non-payment by counter-parties.
“There are also costs to clearing. Margin requirements impose cash demands on ‘end users’ of derivatives, such as non-financial firms who used OTC contracts to hedge risk.
“[House bill] 3795–different versions of which were ordered to be reported by the House Committees on Financial Services and on Agriculture–and Title VII of the Senate Committee on Banking, Housing and Urban Affairs’ comprehensive financial reform proposal provide exemptions from mandatory clearing for certain categories of market participants.
“If exemptions are too broad, then systemic risks, as well as default risks to dealers and counter-parties, may remain.
“The bills seek to balance the competing goals of reducing systemic risk and preserving end users’ ability to hedge risks through derivatives, without causing those derivatives trades to become too costly.”
