Reform: What does it mean?
One look at the new financial market regulatory landscape shows that major changes are on the way. But what is needed to fix the system?
Today's financial regulation overhaul is comprised of an array of structures and solutions - single regulator, systemic regulator, greater cooperation between regulators in the United States and Europe and regulation of over-the-counter (OTC) markets, to name a few. The question for many in the industry is how to move forward in a way that fosters free and efficient markets but does so with safe and sound principles.
"Hindsight feels very powerful and feels like you can see very clearly, but it's really quite dark," says Jacob Goldfield, chief executive officer and chairman of his own hedge fund, JG Fund. "Much of the discussion about regulation that we've listened to is, how are 'we' going to do better than the old 'we.' But you cannot tell what they would have risked in their wisdom."
Indeed, some of the proposals that have been touted in the U.S. Congress often appear to be simple solutions to complex problems of the past. In today's global financial network, however, some answers are not as easy as they appear.
Clearing the way
One of the solutions for today's marketplace centers on clearing. Derivatives clearing houses have been havens of stability in the midst of counterparty meltdowns in the OTC markets. However, the push by some in Congress to simply migrate all OTC trading onto an exchange or clearing house does not fully address some of the root causes of the problem, according to some experts.
Craig Pirrong, professor of finance and energy markets director of the Global Energy Management Institute at the Bauer College of Business of the University of Houston, says mandatory clearing of OTC products has a number of challenges. For one thing, some products are simply not a good fit for centralized clearing structures, he says. Besides, many of the proposals in Washington, D.C. do not focus equally on the counterparty relationships and positions themselves. In other words, clearing products is one thing but collecting the right information on those who trade them may be even more important.
"We might want to be careful in plunging ahead with a complete restructuring of the way counterparty risk is shared," Pirrong says, noting that some OTC marketplaces could be strengthened through post-trade transparency, or non-cleared centralization of trades.
"There are things that exchanges and others can do in terms of improving information, helping with netting and improving standardization," he adds. "Those are valuable things, but I have a concern about mandating sharing of performance risk." Pirrong and others are also concerned about the focus on speculation in financial markets. Many in Congress often tout the $147 per barrel crude oil prices as the poster child for excessive speculation. Much of the blame has fallen on market participants such as swap dealers and index funds. But trading data has shown such participants carried relatively balanced positions in the markets.
"It is impossible to look at that data and determine whether prices are too high or too low," Pirrong says. "There is a more constructive way of looking at these issues, rather than looking at prices and positions. Sometimes the best information to determine whether a market has been manipulated is looking at data on quantities, or physical inventories held."
Much more work would have to go into the physical inventory data collection for accurate information, but it could provide regulators a better view of real fundamentals.
Without better trade and physical information, legislative proposals have singled out various participants as the cause of the price moves. But creating new legislation that excludes various participants or imposes burdensome position limits on them could force them onto other markets, says Craig Donohue, chief executive officer of CME Group.
"They risk pushing people to less regulated markets or markets that do not have position limits or position reporting," Donohue says. "We already see people going to the over-the-counter swaps market as an alternative, or foreign boards of trade or exempt markets where they don't have position limit requirements."
Finding regulatory balance
Of course, there are many ideas about what the regulatory model should look like going forward. Some say it is high-time for the Commodity Futures Trading Commission and the Securities Exchange Commission to be melded into one regulatory agency. Others advocate that the two agencies should remain separate but work on similar "principles-based" rules that allow for flexible but firm regulation of the markets. There is also a push for a systemic risk regulatory body, which some propose should be led by the Federal Reserve Bank or U.S. Department of the Treasury. Others oppose a systemic risk regulatory agency in favor of a systemic risk mechanism or system that is coordinated across multiple agencies when needed. In short, there is no shortage of approaches to regulating these markets in the future. In September, the European Union (EU) proposed a system of three pan-European regulatory agencies that would enforce common rules for banks, insurance and capital markets. Part of that system included a "European Systemic Risk Board," which is comprised of the 27 EU countries with a goal of providing early warnings on threats to the banking system. Whether the United States will complement and cooperate with the EU plan is still unknown, but there has been a push toward more international coordination among regulators.
And what to do with the market participants themselves? Much of the blame has been pointed at the large investment banks and banking community, which moved deeply into the troublesome credit-default swap markets. New ideas about how best to monitor those institutions are coming from a variety of angles. Legislators are debating the issue of bank regulation, and academics are pushing their own ideas about how best to monitor bank and systemic risk.
Markus Brunnermeier, Edward S. Sanford professor of economics at Princeton University, says today's banking regulation only examines banks individually. This, however, has passively allowed banks to grow larger with similar portfolios. In other words, Brunnermeier says the current banking structure is set up so that when banks fail, most or all of them fail, thus forcing the need for a government bailout. His solution to the problem is to encourage more differentiation among banks, so the risk is spread out and is less connected.
"We know that any systems or populations are more robust and more stable if the population is more heterogeneous," Brunnermeier says. "So we want to provide some incentive to be more heterogeneous."
Brunnermeier's approach to regulation of the banks involves what he calls "macro-prudential regulation," which looks at banking risks in a more systemic way. He also advocates a scalable system that requires banks to lower their leverage as they grow – so the bigger you are, the more cash you are required to carry on reserve. Whether Brunnermeier's ideas will be incorporated into U.S. or international rules is still to be decided. But the current economic crisis has opened the door to new ways of looking at risk systemically and approaching regulation for the global marketplace. "When you look at the complexity of our financial markets and financial regulatory system, and the fact that there is such a wide array of regulators with different expertise, different areas of focus, different information, we have come to the conclusion that there is some value to be provided by systemic risk regulation as a function," Donohue says.
This article is based on a September 2009 panel discussion, "Regulation of Speculation and Systemic Risk." The Mathematical Sciences Research Institute sponsored the panel, which was held at CME Group.
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