I tend to be a pro-regulation kind of person. I agreed with President Obama when he said last week that a free market was not supposed to mean free license to take whatever you can get, however you can get it. (Clearly he has not met many traders.)
But the recent hue and cry over OTC derivatives regulation is beginning to annoy me. It appears to be a battle between clearing houses, which stand to gain a LOT if the bulk of derivs have to be cleared, and derivatives traders, which stand to have to PAY a lot (and maybe stop inventing stuff that can't be cleared).
I do believe that OTC derivatives need regulating, and not just because they have attracted a lot of unwanted attention recently. Credit default swaps were one of the culprits often blamed for the credit crisis and for bringing Greece to its knees. And CDOs made the mainstream press (for probably the first time) after one of Goldman Sachs' CDOs was fingered by the SEC last week.
Warren Buffett was right to call them "financial weapons of mass destruction" seven years ago. Not because of the instruments themselves, but because of their enormous growth rate and lack of transparency. CDS took off at light speed: when the International Swaps and Derivatives Association began surveying volumes in 2001, CDS volumes were $631.5 billion. At the end of 2007, 8 months before the credit crisis exploded, they had reached an unbelievable $62 trillion. (Can that really be 9,999% growth? Geeks, please help.)
Processing them was a tedious and mostly manual effort, and was falling so far behind that if anyone defaulted it sometimes took months to figure out who was owed what. But, while a heroic effort by ISDA and an industry working group automated the processing as best they could, the risk associated with CDS and other OTC derivatives was soaring.
Think about it. In the late 1990s/early 2000s traders were still using Black Scholes models and (mainly) individual spreadsheets to calculate their positions. Risk management was a back-of-the-envelope process for the most part, or was partially manual with clerks entering trades into one of the new-to-market risk solutions.
When the enterprise software boom took hold pre- Y2K, major investment banks had to migrate thousands upon thousands of these spreadsheets onto internal platforms. Risk management systems were asset class related therefore risk was managed in silo fashion, with little cross pollination. In the meantime, banks, traders and quants were breeding new instruments like flies. Risk was bubbling furiously under the surface and no one knew it.
Technology is catching up with OTC derivatives, but simply throwing clearing at them will not solve the problems. Complex instruments need to be automated and risk systems must make the downside more transparent, using strenuous stress testing under doomsday/Black Swan scenarios. Capital requirements should go hand-in-hand with the stress testing, i.e. if the worst should happen there is enough money in the bank to pay the bill.
Mandating that OTC derivatives go through the clearing process is a step toward transparency, true. But I worry that the clearing houses themselves are biting off more than they can chew. How many can handle trades that have the potential to double each year in volume?
Also, I know the beast (trading firms), and they will figure out ways to get around it.