Derivatives: Moves to rein in the $600 trillion derivatives market are gaining momentum. Key US lawmakers on Thursday released an outline for legislation that would require standardised contracts to be centrally cleared and traded on exchanges. The European Commission also backs central clearing. It may well make sense for many products. But there’s a danger new rules could go too far.
For one thing, there’s still little consensus over what “standardised” means. If regulators end up herding too-complex products into clearinghouses, it could bog legislation down - or backfire by increasing risk.
That’s because clearinghouses, where liability for losses is shared among members, are most effective when they’re used for products with large, liquid markets – such as the $325 trillion interest rate swaps bazaar. That makes it easier for the clearing firm to find buyers for the contracts caught on its books when a member goes bust. This is a big task – when Lehman Brothers imploded, the clearinghouse it used in London alone had to unwind trillions of dollars worth of trades.
It’s much more difficult to find buyers for customised contracts which, by definition, are at best thinly traded. Hybrid instruments or those with unusual maturities or payoff profiles would be hard to offload. That means the other members of the clearinghouse might have to take a bigger hit if one of their fellows went under.
Granted, the clearinghouse would still disperse the risk of a member’s failure among many other firms, lowering the chance that one failure could cause dangerously large knock-on losses at one or more other institutions. But forcing too many idiosyncratic contracts onto a clearinghouse will reduce its effectiveness nonetheless.
Watchdogs may want to require as many types of contracts as possible to be centrally cleared. But they can vastly reduce systemic risk by addressing the massive markets for plain-vanilla – and easily cleared – products like credit and interest rate swaps, or foreign exchange contracts. Beginning with products everyone agrees are standard is also a way to avoid bogging the legislation down in details of definition. It makes sense to start with the abundant low-hanging fruit.