Derivative trades don't all belong on exchanges

Judd Gregg

Two years after the onset of one of the worst financial crises since the Great Depression, Congress continues to grapple with the overhaul of the US financial regulatory structure.

We can all agree that system-wide reform is necessary to protect American taxpayers and to ensure a safer, stronger and more efficient marketplace. However, regulatory reform is a complex undertaking and should not be used as the latest venue for political theatre. It is far more important to get this done right than to race blindly toward an artificial deadline simply to get it done.

Providing a framework for the regulation of the over-the- counter derivatives market is a key component of any comprehensive reform bill. Congress is currently considering several proposals that each provide important steps to address transparency and potential systemic risk in the OTC market.

These steps include reporting of trades, increased opportunity for clearing, sufficient cushion in the form of risk-based margin or collateral, heightened capital requirements, as well as detailed market participant record keeping for ongoing regulatory review.

All of the current proposals, however, go one step too far by mandating that trades of these complex financial risk-management tools be executed through an exchange. Such a requirement would result in significant and harmful economic costs without providing the intended safety and soundness benefits.

A central problem of mandating exchange trading is the potential market liquidity risk that would accompany it.

During 2008 the world was reminded that liquidity problems, though typically infrequent, are high-impact events.

Liquidity risks are commonly interpreted as cash or funding risks, but market liquidity also represents the ability to execute transactions. Congress's aim for OTC regulation is to reduce systemic risk to the financial system by, at the very least, providing an efficient regulatory structure that reduces the frequency and severity of market liquidity problems.

By and large, the swaps market is a wholesale, institutional market where most trades are large, block-sized transactions. Mandatory exchange trading would reduce market liquidity and increase execution costs for the ultimate end-user of these swaps. Advocates for mandated exchange trading want to decrease bid-ask spreads, which would theoretically lower the cost of these products, but they fail to understand the market sensitivities.

Mandating real-time dissemination of swap transaction price and quote data will require market participants to announce their trading interests to the entire market and allow others to step in front of their trades, moving the market against their hedges. In such an environment, market liquidity for swap transactions will decrease dramatically, if not disappear altogether.

Both the UK's Financial Services Authority and the Committee on Capital Markets Regulation in the US recently came out in support of policies that promote the movement toward exchange trading, but not an explicit government mandate. Even CME Group, the world's largest futures exchange operator, has communicated to the Commodities Futures Trading Commission that while some swap transactions are standardised enough to be tradable, others are not, and industry migration toward exchange trading is more appropriate than a mandate. As we move forward in our reform efforts, I hope my colleagues will keep in mind the important role derivatives play in our markets. Derivatives regulation should seek to foster a sound, competitive and liquid marketplace, while preserving the flexibility for market participants to hedge risks.

However, if Congress does not remain focused on these worthwhile aims, we will unintentionally create global regulatory arbitrage and the flight of capital to less-regulated jurisdictions overseas. Such a one-size-fits-all mandate will draw capital away from the United States, reduce innovation and job creation, and do fundamental harm to our free market economy.


- The author is a Republican senator from New Hampshire who serves on the US Senate Banking Committee. The opinions expressed are his own


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