Derivatives and the Wisdom of Crowds
Smart reform yields more information, not more regulation.
In the early days of the credit crisis, some in Congress wanted to ban financial derivatives. Others wanted a Financial Product Safety Commission, modeled on the Consumer Product Safety Commission, with a bureaucracy to approve or recall financial instruments. The good news is that last week's administration proposals for how financial markets should operate are focused on better disclosure instead of micromanagement.
Financial derivatives -- instruments whose value is derived from other assets -- are ways to measure and reduce risk. Banning them would have been like shooting the canary before it was sent down the mine shaft. Almost every large company uses derivatives to reduce the risk of changes in interest rates, currencies, supplies or the chances of a credit default by one of its commercial counterparties. Airlines hedge their purchases of fuel. Traders at banks and hedge funds use them to take positions on future price movements, in the process bringing important information to market.
Treasury Secretary Timothy Geithner's proposals focus on disclosure of the derivatives positions taken by banks and brokerages in order to help regulators spot excessive leverage. Derivatives traders would have to report their trades and overall positions to regulators and could have their capital requirements adjusted. This makes sense, though regulators already had access to key derivatives information through banking regulations, with the ability to track cash flow at every bank.
Indeed, the credit bubble is a reminder that above all regulators need to know what to do with information once it's disclosed. Bank regulators had access to the information to know who was at risk for how much, which should have alerted them to systemic risk among brokers, AIG and others. Yet regulators weren't able to predict the implosion any better than the banks. This is one reason to blame regulators, even if the responsibility for what turned out to be lousy trades rests with banks.
But beyond alerting regulators and the markets to the positions held by banks and brokerages to manage systemic risk, disclosure about derivatives brings valuable information to the broader investing community. The Treasury proposals focus on disclosing trades to regulators, but the greatest value could be in disclosing aggregated data to the public, released anonymously to protect trading strategies.
This public disclosure could bring the wisdom of crowds -- many investors processing information -- to a new area of the market. Information about equities makes stock markets highly efficient, with prices quickly reflecting accumulated knowledge among investors. Disclosure of derivatives positions could likewise help make forecasting more accurate for more esoteric topics like interest rates, foreign-exchange movements and corporate credit risk.
It's important that disclosure should not undermine markets. In this regard, it's surprising that Treasury would create more systemic risk by putting hundreds of billions of dollars in derivatives into concentrated positions at a few clearinghouses. The rationale is that this would make it easier for regulators to gather information, but there are ways to centralize information without centralizing trading risk.
"It's counter to the goal of reducing systemic risk to put all the risk in one place, if that concentrates the risk of trades in clearinghouse institutions that would be 'too big to fail,'" suggests Mark Brickell, a longtime swaps banker now with an online derivatives platform called Blackbird. "It's also unnecessary. With today's ability to gather information electronically, we don't need to put all the risk in one place. We can just aggregate all the bank information in one place, so that regulators know the exposures of all the firms."
As the onerous requirements of Sarbanes-Oxley showed, disclosure of information that isn't especially useful is not worth the price. Regulations shouldn't raise the cost of using derivatives to manage risk. The Treasury proposals may go too far, for example, if they apply similar rules to the use of derivatives by corporations, which doesn't present systemic risks, as to their use by banks, which does. This could unnecessarily raise the costs of risk management by companies.
New regulations should make financial markets as transparent as possible while ensuring they still function smoothly. It's a good sign that regulators understand derivatives need to retain their key role in reducing risk. Washington is focused on which regulatory agency ends up with the winning hand, but the more important point is that a smart reform is one that yields more information rather than more regulation.
Regulatory overreaction remains a systemic risk. It's encouraging that the debate over once-controversial derivatives is now over the finer points of disclosure. Markets are still looking for stability, including in how the markets themselves operate and how wisely they will be regulated.
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