Written By: Leslie Sutphen, President, Financial Markets Consulting, LLC
There has been much talk about repealing most of the Dodd-Frank act now that we have a change of party in the Presidency. To many in the futures industry, this seems like a good thing; however, in determining whether the Volcker Rule and Title VII of Dodd Frank should be repealed, it is important to remember why Dodd-Frank was passed to begin with. The act was designed to address very real issues with lack of regulation, lack of transparency, and poor risk management practices that brought about the Financial Crisis of 2007 to 2008. Wholesale repeal of the Act would result in a return to the very risky conditions that developed with the massive deregulation that occurred from the late 1970s through the early 2000s.
The financial crisis was caused by a proliferation of sub-prime lending and the bundling of risky mortgages into collateralized debt obligations hedged by the issuance of credit default swaps. These derivatives were created in an environment of lax supervision, poor transparency, misleading ratings, undercapitalized and overleveraged institutional investors, and concentration of secondary market liquidity among a handful of large investment banks and non-bank financial institutions. The Dodd Frank Act implemented many safeguards that will prevent this situation from developing again.
First, it enacted the so called Volcker Rule which restricts the ability of deposit-taking banks to invest in hedge funds or to trade risky derivative products except to facilitate customer business or to hedge their own assets. Although this has contributed to a temporary reduction in liquidity in some asset classes, it has also provided great opportunities for a wider diversity of trading firms and hedge funds to provide liquidity in new and interesting products. Ultimately, not concentrating market-making in the hands of few large institutions will create healthier and more transparent markets with greater accuracy of pricing and wider opportunity for hedging and risk management. In addition, the separation of risky investing from provision of consumer deposit-taking and lending will enable investors and regulators to have a better picture of the risks being undertaken by the institution.
Second, the Act implemented new capital and margin requirements for swap dealers. This addresses the poor understanding of risk and credit among financial institutions who invested in these instruments prior to the crisis and who accumulated risk beyond their tolerance levels. Those of us who grew up in the futures markets have long been comfortable with the concept of initial margin and mark to market variation margin. The system enables a wide variety of market participants to engage in these markets without an onerous credit process – and the immediate liquidation of positions when a margin call is not met prevents a large build-up of exposure to significant volatility in pricing which results in widespread and abrupt failure of financial institutions who have underestimated their exposure. Subjecting complex derivatives to margin and to real-time price valuations is a sure way to address risk as it occurs instead of when it is too late.
Third, the Act implemented reporting requirements for swaps trading. Again, those of us in the futures market would be very surprised to trade an instrument where there is no ability to gage the true price – where we had not idea of the price of the last trade or the volume that had been traded. As the financial crisis unfolded, regulators and investors were unable to determine the value of the derivatives exposures and indeed unable to trace ultimate ownership of some of the underlying instruments. This made orderly liquidation of positions and institutions all but impossible, and the federal government often had to bail out institutions without a clear understanding of what it might cost. Although it has taken time to work out the standards for reporting of swap data and to coordinate with international regulators on the mechanisms for such reporting, I would argue that the availability of detailed swap transaction data provides a foundation for greater participation in market making and trading of these instruments.
Fourth, the Act requires registration of swap dealers and major swap participants. The largest defaults leading up to the financial crisis occurred in lightly regulated non-bank financial institutions such as Countrywide Mortgage or AIG. And investment banks such as Bear Stearns and Lehman were able to hide much of their CDO and credit derivative activity in special investment vehicles that were not subject to the overview of their regulators or Self-Regulatory Organizations. I think it is important for regulators to have access to and oversight of those financial players who are major participants in trading activity. While we can argue about the form of that registration and its attendant requirements, I think it is nevertheless important that no major participant create exposures that are not under the oversight of the regulator.
Fifth, the Act requires mandatory clearing and exchange trading of certain swap contracts. This is perhaps the most controversial of the Act’s recommendations and the one that has likely resulted in the biggest shifts in market structure and types of market participants. However, those of us in the futures markets have seen firsthand that instruments that trade on a clearing model as opposed to a bi-lateral, negotiated credit model, are accessible to a broad spectrum of market participants and are much less susceptible to massive credit instances than many of the over the counter markets. In addition, exchange trading, especially in an anonymous central limit order book, is an ideal mechanism for promoting price discovery and fair and liquid markets. It is true that not all instruments trade with the liquidity of the futures markets and may require more flexible exchange structures than the central limit order book; however, we have already seen how markets migrate to exchange trading naturally as they mature by observing what has happened in the US Treasury market where active electronic platforms have promoted liquidity and attracted new participants.
Finally, under Section 747 of Title VII, the Act implemented specific prohibitions against spoofing/market disruption. Spoofing is defined as “bidding or offering with the intent to cancel the bid or offer before execution”. This particular law has nothing to with the financial crisis so it is a bit of a strange insertion. Nevertheless, the markets have always struggled with differentiating between legitimate and deceptive trading behavior. In the days of floor trading, a trader could just choose to ignore a trader who always backed away from his bids or offers. However, in the anonymous world of electronic trading, this has become more difficult. Exchange regulators have struggled to develop detailed descriptions of what constitutes spoofing and what constitutes legitimate market making, cancellation, and order placement. I think that any attempt to formalize the rules for market behavior is constructive and can help promote transparency and liquidity in markets.
All in all, I think these new laws have promoted greater transparency, liquidity and risk management in the over the counter derivatives markets. It is true that some of the resulting regulations have proved to be overly prescriptive and excessively costly to implement, but that argues for a revision of the regulation in light of new data not for a wholesale rejection to the laws designed to protect our markets from the excesses experienced in the last crisis. If we can continue to work collaboratively as we have for many years to develop sound market structure with fair rules and efficient oversight, we will all be able to experience markets that are perceived as fair and transparent.
Financial Markets Consulting, LLC