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William Dudley on fixing global derivatives

by Robert Teitelman | Published April 16, 2012 at 12:10 PM

New York Federal Reserve chief William Dudley pops up in the Financial Times this warm Monday to allay our fears about the risk of derivatives. In a piece cheerfully headlined, "How we will stop derivatives magnifying future crises," Dudley dutifully marches through information that we mostly already know. The Lehman Brothers collapse left a big mess; the $119 trillion over-the-counter derivatives market was extremely opaque, particularly in the middle of the crisis; that opacity made determining positions difficult and forced counterparties to demand more collateral. The remedy? Well, if you've been paying attention you know that too: more standardized trading and a system of what Dudley calls central counterparties (which I assume means both clearinghouses and exchanges).

Dudley is writing all this on the day the Committee on Payment and Settlement Systems (a unit of the Bank for International Settlements, dominated by central bank types) and the International Organization of Securities Commissions (which brings together regulators of securities markets) are releasing "global standards," which "impose rigorous stress testing and margin requirements to guard against potential exposures even in extreme conditions."

What will this create? "Properly structured and regulated, global central counterparties can reduce more risk than a multitude of national and regional ones," he writes. Of course, there are concerns, but do not fear, the standards take care of them through four safeguards (I'm not sure you're allowed an FT op-ed unless you can tick off at least four points somewhere). "The first is a framework for international oversight of central counterparties. The second is a requirement that global central counterparties must allow open access on terms that promote competition. The third is a standard that a central counterparty must have adequate emergency liquidity in all the currencies in which it operates. And the fourth is a requirement that each central counterparty builds in procedures by which -- in the highly unlikely event that its own viability is threatened -- it could be capitalized or wound down in an orderly way."

Dudley is upbeat about all this. My favorite example of optimism meeting reality is his line, "In the highly unlikely event that its own viability is threatened." It's true, Dudley never really tells us what power these international organizations have, whether these standards are anything more than NGO talking points or whether they've been approved by any sovereign state, including Dudley's own. We know how much jockeying has gone on in the U.S. and Europe over this issue, with deep tensions between exchanges and counterparties, between venues, between dealers, regulators and corporate users, between different kinds of derivatives. Where is the International Swaps and Derivatives Association on all this? Do these standards supplant Dodd-Frank? Or is this like the BIS's other longstanding project on capital ratios: a country-by-country negotiation process, which, when completed, may be operating in a world fundamentally different than the one it was designed for (see Basel I, II and probably III)? Indeed, the sheer underlying complexity of interests and governance of these two technocratic organizations, the Basel-based CPSS and Madrid-based IOSCO, could be either good or bad: either a testimony to unanimity or an agreement that papers over all kinds of fissures and contradictions. (That said, broad membership in these NGOs is often the enemy of effectiveness. Like the United Nations, the real power lies in who has the votes: the biggest members or the large number of smaller players. Untangling how these organizations work means working out how power flows in complex bureaucratic structures.)

Anyone who wants to adopt Dudley's cheer should recall that his predecessor at the New York Fed, Treasury Secretary Timothy Geithner, tried to get a clearinghouse infrastructure put together voluntarily by the industry in 2004 and failed miserably, since there was none in 2008. Now we've gotten this four long years after 2008.

Those four safeguards sound swell, but pessimists among us may still be anxious, beginning with Dudley's quiet, if potentially lethal, qualifier: "properly structured and regulated." Dudley seems to be admitting here a gap between idea and execution. What is that "framework for international oversight"? How will it avoid national or industry competition? Why should anyone trust a bunch of global regulators any more than national regulators who managed, among other sins, not to take these steps many years earlier? In effect, these global counterparties represent dikes erected before a crisis reaches governments and central banks. Like banks, counterparties that are so heavily capitalized to provide liquidity in an emergency might not be viable as businesses, even as utilities. If we worry about their operating viability (as their shareholders clearly will), there will be pressures to reduce capital reserves. Given the dynamic character of global markets, this will require close regulatory oversight, analysis and monitoring. This, in fact, is exactly a situation ripe for regulatory capture, particularly since some regulators will be "global," that is, based at some distance from the actual location of the global counterparty, and some will be local, with all that that implies. And will they be able to keep up with a rapidly changing, and growing, market? Lastly, these safeguards mandate the same sort of resolution authority that Dodd-Frank tosses up in defense of failing too-big-to-fail banks. There is widespread skepticism about the efficacy of as-yet-untested living wills and anything-to-avoid-a-bailout provisions. How will this winding down function in a global context? How long will it take to negotiate those provisions? And by creating these global counterparties, aren't you only increasing the number of TBTF institutions?

Are global counterparties a good idea? Well, short of returning to the derivatives free-for-all we've had in the past or banning them, they may be the only viable idea (despite the TBTF problem), just as resolution authority is about the only protection against TBTF if you don't break up the banks or mandate much higher levels of capital. But we are not there yet, certainly not on the regulatory front. The need for global counterparties may be a grand idea operationally (so was the euro until it wasn't), but it raises all the usual questions of governance and coordination. Even Dudley, as he wraps up this op-ed and takes off down the road he calls optimism, admits, "Much still remains to be done." And that from the man who, soon after taking office, expressed the sentiments that bubbles wouldn't be that hard to recognize and deflate. - Robert Teitelman

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