Summary:
– Derivatives are not the cause but a factor in the spread of the financial crisis that began in 2007. Trading these products on over-the-counter markets has limited the ability of authorities to estimate their importance.
– A regulatory solution was put in place by clearing houses to supervise transactions and payments on regulated markets, ensuring greater transparency and organization of financial markets.
– However, clearing houses will bear an increasingly heavy burden of risk coverage, which could make their failure dangerous for the entire financial system. In addition, non-standardized derivatives will escape this regulation.
Derivatives were often singled out as a factor in the economic and financial crisis. Traded directly between players outside regulated markets, they were subject to little oversight. In 2009, the G20 in Pittsburgh recognized the lack of transparency and traceability in these markets, and its desire to introduce new regulations on derivatives was reflected in the European EMIR directive, which will come into force in early 2013, and in the Dodd-Frank Act in the United States.
The aim of this regulation is therefore not only to improve the supervision of derivatives markets, but also to create compensation mechanisms in the event of the bankruptcy of a financial institution.
This article aims to provide a better understanding of how derivatives markets work, the mechanisms on which the new regulations will be based, and finally, the questions that remain unanswered.
Risks associated with derivatives
Derivatives are mainly based on forecasts: they are contracts in which agents set in advance the price at which they can buy or sell a certain quantity of underlying assets, which may be financial (stocks, bonds, exchange rates, etc.), physical (commodities, etc.) or even any other event with an economic impact (bankruptcy, climate, etc.). The best known and most widely reported of these are credit default swaps (CDS), which are used to hedge against the risk of default by a borrower. etc.), physical (commodities, etc.) or even any other event with an economic impact (bankruptcy, climate, etc.). The best known and most widely publicized of these are credit default swaps (CDS), insurance contracts that protect the buyer against changes in an underlying asset in exchange for the payment of a premium.
While the initial purpose of derivatives was to reduce risk, paradoxically, they have increased it. This is because when some agents anticipate an increase or decrease in the underlying asset, others speculate on the opposite trend. The presence of speculators is certainly necessary to ensure market liquidity, but they often invest using significant leverage, i.e., borrowing from banks with minimal initial resources while hoping for significant financial returns. If their predictions prove wrong, it is not only the speculators who are affected, but also many banks.
As CDSs are backed by an underlying asset that is subject to increased risk, the premiums on these CDSs will increase, leading to a decrease in the profitability of financial institutions and an increase in their risk of default. This will further increase the premium on other associated CDSs, creating a negative spiral.
Finally, as these products are traded without traceability on the markets, the climate of uncertainty grows because financial institutions have little knowledge of the market positions of other players. The imbalances are exacerbated by the fact that supply was more concentrated among a small number of players, while demand was more dispersed.
To illustrate the risks associated with derivatives, the American company AIG sold CDSs backed by subprime mortgages before 2007 and went bankrupt before being bailed out by the US Treasury. This explains why public authorities want to increase the transparency and resilience of derivatives markets.
Over-the-counter derivatives markets and dark pools:
Before the new regulations, the trading volume on OTC derivatives markets was difficult to quantify.
Derivatives can be traded on two markets: regulated markets, where trades must go through a clearing house within organized exchanges, and over-the-counter (OTC) markets, where trades are made directly between buyers and sellers and clearing houses are not mandatory.
In reality, a very large proportion of derivatives are traded on OTC markets. According to the Bank for International Settlements, nearly $628 trillion worth of derivatives with a market value of $25 trillion were traded on these markets in June 2012, which is about 10 times more than on organized markets. There are also over-the-counter markets where the players are anonymous: these are known as dark pools, where prices are not disclosed and no regulations apply.
Given the large amounts traded on over-the-counter markets and the lack of transparency in dark pools, the need for better supervision of these products by a clearing house has become increasingly apparent.
The regulation aims to regulate the market through a clearing house, which will therefore bear a greater risk of default.
The G20 has therefore recommended that derivative transactions be conducted through a regulated market with the presence of a clearing house.
A clearing house is a structure that records orders and intervenes in the event of default by a buyer or seller by fully compensating the injured party so that the initial commitments are met. If necessary, it does so by substituting itself for the defaulting party. To guarantee transactions, it requires market participants to pay a security deposit at the start of the transaction and then margin calls.[1]when prices fluctuate.
This reform therefore aims primarily to give clearing houses more scope to:
– enhance the transparency of over-the-counter markets by registering transactions with these clearing houses.
– gain an overview of these markets in order to prevent abuses and excesses in advance, thereby strengthening overall confidence in these financial products and the entities that use them.
– prevent failures from leading to bankruptcies with systemic repercussions[2]through a generalized clearing system.
However, certain new risks may still arise.
Systemic risk may be transferred to clearing houses, which will not take non-standardized products into account.
This regulation can only give greater visibility to derivatives transactions, which have grown enormously thanks to financial innovation since the 1980s and particularly since the 2000s. However, several difficulties remain with this new regulation.
(1) First, clearing houses will concentrate even more risk than before.
Clearing houses constantly manage a very large number of transactions with major financial institutions, which means that in the event of a crisis, the risk they represent, which is greater with the reform, can become systemic, i.e., it can affect a very large number of financial players. Furthermore, in the case of CDSs, the clearing house will have to deal with the risk of default not only of the CDS counterparty but also of the underlying asset.
This systemic risk means that clearing houses are subject to particularly strict regulation by the authorities. To counteract this risk, margin calls would have to be higher than they are at present, which would make the derivatives market less attractive. The conditions required for clearing houses (collateral, margins, etc.) could then become significant, allowing only large financial players to participate. Furthermore, in the event of default, the shareholders of clearing houses, often large financial institutions, would invoke the impossibility of bailing out these clearing houses and request assistance from public authorities.
The challenge of reform is therefore to increase the transparency of derivatives markets in order to anticipate these risks upstream, but this means avoiding excessive concentration of clearing houses.
It should be noted that economist Jean-Charles Rochet has observed that clearing houses have weathered recent crises well. He adds that to avoid systemic risks, they could participate in the creation of « systemically important platforms » that would host financial institutions; these institutions would be the only ones approved by central banks to be bailed out by the authorities in the event of bankruptcy, while also being able to be excluded from the club at any time. However, this idea has not been adopted for the time being.
(2) Non-standardized products will not be regulated
A standardized derivative is a product where the terms of the contract are standardized, while a non-standardized derivative is traded bilaterally according to rules directly defined by the buyer and seller. The new regulations will require a clearing house for standardized derivatives, but not for non-standardized products. This is because clearing is complex for very specific transactions, which often involve higher risk.
However, the derivatives that led to the bankruptcy of AIG, for example, were mostly non-standardized, suggesting that the previous crisis could not have been avoided by this type of regulation. But non-standardized products will be subject to higher capital requirements.
(3) Global harmonization
Finally, for this regulation to be effective, there must be global harmonization of the rules on derivatives, to prevent them from being traded mainly on over-the-counter markets that are not subject to this reform, with the aim of avoiding paying margins. This is the whole point of having this G20 rule transposed by all its members.
This harmonization must also extend to the management of clearing houses. While competition between clearing houses may reduce the systemic risk mentioned above, it must not lead these houses to demand lower guarantees than their competitors in order to attract financial players. This would weaken the clearing role of these houses. It is therefore necessary for all clearing houses to follow the same management rules.
Conclusion
2013 will see the implementation of new regulations on derivatives in Europe with the EMIR directive. These will no longer be traded directly between buyers and sellers, i.e., on an over-the-counter market, but will be subject to mandatory clearing. The aim is to improve the traceability and transparency of derivative transactions, but also to reduce the risk of systemic failures in these exchanges. However, this systemic risk may unfortunately be transferred to clearing houses, which will now bear these default risks. In addition, non-standardized derivatives will not be subject to mandatory central clearing. Nevertheless, the authorities, aware of these limitations, could prohibit excessive concentration of clearing houses and strengthen their supervision in an attempt to avoid a new crisis in the derivatives markets.
Notes:
[1] Margin calls are sums requested by clearing houses to replenish margin deposits that may be impaired by market fluctuations.
[2] Systemic risk is a risk that jeopardizes the entire financial system.
Sources:
– « Reducing systemic risk in over-the-counter (OTC) derivatives markets, » Nout Wellink, Financial Stability Review No. 14, Banque de France, July 2010.
– « Over-the-counter derivatives and central clearing: can all transactions be cleared? », John Hull, Financial Stability Review No. 14, Banque de France, July 2010.
– « Systemic risk: an alternative approach, » Jean-Charles Rochet, Financial Stability Review, Banque de France, July 2010.
– « Derivatives at the heart of the crisis, » Christian Chavagneux, Alternatives Economiques Special Issue No. 87, December 2010.
