The Treasury Department has proposed regulating derivatives like CDS by forcing the bulk of them on to centralized exchanges (see http://www.treas.gov/press/releases/tg261.htm for the summary, or if you are really ambitious, here is the link to the actual proposed legislation http://www.financialstability.gov/docs/regulatoryreform/titleVII.pdf). Thus all standardized derivatives would start to resemble the market for equity options.

The move would greatly reduce the possibility of a cascading wave of cross defaults if one major player were to fail. This is precisely the situation that was faced last fall with the collapse of American International Group (AIG).

It was the fear of that domino effect that caused the Federal Government to throw $180 billion at AIG. Most of that money went straight out the back door to fulfill AIG’s CDS swap obligations. Over $12 billion of that went to Goldman Sachs (GS), who’s chairman was the only private sector person at the table as the AIG rescue plan was discussed.

This legislation has the potential to prevent a reoccurrence of that disaster. (Disaster from the point of view of the taxpayer, not so much from the point of view of GS, but then again who is more important to the Treasury, under either party: the taxpayer or Goldman? If you answered the taxpayer, then go out to the stable, your pretty pink unicorn needs to be fed).

This is a significant first step, but does not appear to go far enough in my opinion (I will have to read the whole legislation but have not had a chance yet). One of the problems is that term ‘standardized’. It will be very easy for the investment banks to tweak the terms just a bit to make the contracts customized, and thus keep them off the exchanges. Customized derivatives are FAR more lucrative to the investment banks than are standardized contracts.

Since there is a large element of a zero sum game here, if you ever get into a situation where an investment banker suggests you buy some sort of a customized derivative, my advice is to slam down the phone in mid conversation without even saying good bye. However, such advice was not often followed and countless small institutions got sucked up into the trap (less so with individuals but it happened there too).

The proposal attempts to prevent “fake customization”:

 

  • “Through higher capital requirements and higher margin requirements for non-standardized derivatives, the legislation will encourage substantially greater use of standardized derivatives and thereby will facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges.
  • The legislation proposes a broad definition of a standardized OTC derivative that will be capable of evolving with the markets.
    • An OTC derivative that is accepted for clearing by any regulated central clearinghouse will be presumed to be standardized.
    • The CFTC and SEC will be given clear authority to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.

This could work, but much will depend on just how much higher the capital and margin requirements are for the non-standardized derivatives. Much will also depend on who is running the CFTC and the SEC, and how vigilant they are.

If these rules were in place during the last administration they probably would have accomplished nothing. With the current administration, they might help a little, but I suspect that there will still be a lot of unneeded customization aimed at avoiding the exchanges.

There was nothing in the press release about the banning of naked CDS. This is a huge omission. A CDS is sort of like a life insurance policy on a company (see http://www.zacks.com/stock/news/14884/Credit+Default+Swaps+Explained for a full explanation) but with life insurance you can only take out a policy on someone you have an “insurable interest” in, for example yourself or your spouse. You can’t just go wandering the halls of the nursing home looking for good prospects to take out a policy on. And a surgeon is certainly not allowed to take out a policy on a patient he is about to operate on. Unfortunately there are no such restrictions on CDSs and it is a disappointment that the proposal does nothing about it (at least mentioned in the press release.)

While I hope that Congress strengthens this proposal, it is a welcome first step and is much better than the current situation.

Read the full analyst report on “AIG”
Read the full analyst report on “GS”
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