Derivitive regulation

NY Times Editorial:

The Obama administration has made a serious proposal to regulate derivatives — the multitrillion-dollar market in financial contracts that malfunctioned so disastrously last year. The plan goes further than many thought politically possible, especially in its call for federal oversight of all large derivatives dealers. But it does not go far enough.

Those dealers — including big banks like JPMorgan Chase, Goldman Sachs and Morgan Stanley — trade derivatives mainly as one-to-one private contracts, largely without any regulation. The plan would allow regulators to impose rules on dealers and track their activities and presumably put a timely halt to abuses. But it does not demand the full transparency that would come from trading all derivatives on exchanges, like stocks.

Exchange trading allows the market as a whole — investors, economists, researchers — to see how derivatives are structured, priced and traded. Such knowledge is the best defense against speculative excesses.

The plan would require that derivatives that are deemed “standardized” — off-the-shelf contracts with mostly boilerplate language — be traded through a central clearinghouse or on an exchange. But the plan would also allow for “customized” derivatives — no one knows yet with certainty what the difference would be — to continue to be traded privately.

The danger of perpetuating a freewheeling market in customized derivatives is real. The decision to rope them off looks like a sop to the banks, which have fought against disclosure and transparency. They know that customers who rely on derivatives — including investment funds, major corporations and wealthy individuals — would likely pay less if they could compare prices.

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Until there is an understanding of the risks in the derivatives the regulation will not make much difference. The problem stems from a misguided attempt to quantify the risks before the melt down rather than doing standard due diligence on each derivative contract. This is not unlike doing a risk analysis on a roulette wheel. It is why the market seized up when no one was able to assign a value to the contracts in bank portfolios. If they had done individual due diligence on each contract it would have been easy to assign a value because they would know which mortgages in each contract were in default or were subprime borrowers upside down on their loans.

There is also the problem of quantifying the leverage in these derivative contracts. It must be significant in some of these to achieve the kinds of losses sustained by the holders. The commodities market have an established procedure of requiring people who hold contracts to put up more money if the market moves against them or to sell the contract if they don't have the money. A similar procedure is needed in the derivative market.

There is further a fundamental question about the value of derivatives that has not yet been addressed. The original rationale for them was to create liquidity in the mortgage markets. That have had the opposite effect since the real estate meltdown. Perhaps they are not worth the risks they have created.