Dawn of a New Era in Global Financial Markets
Over the past decade, globalization, electronic trading and new products were just a few of the influences in financial market evolution. now the global financial crisis promises to re-shape financial markets and regulation for the 21st century.
The U.S.-sparked credit crisis has triggered a massive chain reaction throughout economies around the globe in a way that was previously unimaginable. In addition, the crisis is likely to reshape the way financial markets operate in the future. The demise or redefinition of mammoth investment banks, the pummelling of global stock markets, and the prospect of a long and severe recessionary period will catapult regulation onto almost every government's to-do list.
"The interconnectivity of world markets is very high, so much that each country is focused on the other," says Robert Shiller, professor of economics at Yale University. "If one country has a big move, we react in our own country."
Concerns about counterparty risk continue to mount, with accusatory fingers pointed at OTC derivatives. Prudent institutions want to limit bilateral credit risk as much as possible. "The issues in the OTC derivatives market were with transparency and valuation," says Andy Nybo, senior analyst with consultancy Tabb Group in Westborough, Mass. "The OTC derivatives market is broken but not dead. Central clearing could be a lifeline for certain types of instruments."
Then and Now
The financial world has changed dramatically in the years leading up to the current crisis. A decade ago, exchanges were mainly member-owned entities. Electronic trading was just starting to gain acceptance, with alternative trading systems and electronic communications networks the budding stars. Crossing networks, dark pools of liquidity and block trading were the infant offspring, waiting on the sidelines for electronic trading to mature
Today, electronic trading and information dissemination are so fast they are measured in milliseconds. This speed helped to exacerbate the reaction to the credit crunch, as fear spread like lightning through developed markets and into emerging markets. The irony is that credit derivatives have been one of the least electronic of instruments and constitute a bilateral, manually traded market.
Years ago, "Fear Factor" was not even a television reality game show - never mind the mindset of millions of investors. As Paul Volcker, former chairman of the Federal Reserve, said at CME Group's Global Financial Leadership Conference in September 2008, "The markets have moved from exuberance to fear, from greed to fear - and it's the fear that's driving values today. The market today tends to focus on what is perceived as the weakest link in the chain. It's like cougars going after a wounded lamb, and it leads to an insidious chain reaction."
Regulatory Concerns
This chain reaction has kept politicians and regulators exceedingly busy over the past year, which means there has been little time for a knee-jerk regulatory reaction. That's probably for the best.
Joel Naroff, president and founder of strategic economic consulting firm Naroff Economic Advisors, says an immediate regulatory reaction would have been too extreme, as it was when the dot-com bubble burst, Enron collapsed and the Sarbanes-Oxley Act was passed.
"If the circumstances were different and not so severe, Congress would be all over it - over-regulating the markets," says Naroff. "This gives them time to take a breath."
Some markets, however, would benefit from increased regulatory protection. A heretofore unglamorous business is now in the limelight, as the immediate momentum toward credit derivatives regulation has led to calls for increased central counterparty clearing to help alleviate the kinds of counterparty risk seen last year.
In fact, centralized clearing is the one immediate and proven solution at hand, according to the Commodity Futures Trading Commission's former acting chairman, Walter Lukken: "When transactions are cleared, government and exchange regulators receive trader and pricing information, which helps them to police for manipulation and fraud and to uphold the integrity of the market."
Central counterparty clearing gives market participants a chance to reduce risk while continuing to trade OTC derivatives. New regulation of derivatives may have unintended consequences because few outside the participants truly understand them, says Nybo. He suggests that regulators wait until "cooler heads" prevail. "Regulators have too many things on their plates right now," Nybo explains. "The Securities and Exchange Commission, Treasury and FDIC have their hands full. Their understanding of OTC derivatives is sketchy at best, and the political and legislative bodies for sure don't understand them
Risk Management and Transparency
Financial institutions need to come to grips with risk management, taking a more balanced view of risk versus reward. OTC derivatives produced lots of rewards over time, but the risks eventually far outweighed them. Shiller says the current crisis reveals the flaws in risk management practices: "They blame the complexity of the instruments. Some firms think this is a good reason not to do risk management. But if there were a plane crash, would everyone stop flying? Airplanes are extremely complex, but humans can handle them."
If firms trade OTC and clear their transactions using exchanges and clearing houses, counterparty risk is lessened and information is more readily available. Nybo says exchanges are of particular benefit in times of stress because they are regulated and have a good understanding of the challenges, plus the technology and the financial wherewithal to withstand the turbulence. "They have a clearing mechanism in place that works well for options, futures and cash," he states.
With the new administration in place and regulatory proposals proliferating, Shiller says, "I expect to see more regulation, a new blueprint. This time, it will be more 'macro prudential regulation,' which was not a focal point before.
The "fear factor" will wear off eventually, and the financial markets will emerge battered but alive. Naroff says that the extent of the fear might be the silver lining in the current economic thunderstorm. "What we know about human nature is that when people are in a painful situation - an environment they didn�t think they could live in - they adjust to it. People don't hold on to extreme emotional feelings." Neither do markets.
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