Thursday, June 23, 2011

Q&A Series – Derivatives Regulation

This week’s question comes from Sue, a client who is concerned with how the lack of regulation and the enormous size of the derivates market can pose risks to her investments.

Q. To what extent does the continued lack of OTC (over-the-counter) derivatives regulation jeopardize the personal accounts of “little guys” like me?

Politicians, regulators and financial institutions continue to debate this very question, Sue, and although I acknowledge that we aren’t experts in the field of derivatives, I’ll attempt to answer it.

In some ways, not much has changed since the financial crisis, but in other ways, the overall landscape is much different than it was in 2007. Banks and financial institutions are bigger than ever, but on the other hand, they are far better capitalized compared to 2007 and have been held to higher regulatory standards since the crisis. In addition, financial institutions are far more conservative in their lending and investment initiatives than in years past. More regulation, more capital and more conservative lending standards all contribute to a far more stable, if less profitable, environment. For these reasons, we feel that the risk due to a lack of specific OTC derivatives regulation is far lower today than a few years prior.

Derivatives are used by a wide variety of market participants. Many corporations and industries use derivatives to hedge specific risks, which translates into more stable prices for consumers and businesses. Farmers might hedge against lower crop prices and, alternatively, food producing companies might want to hedge the risk of rising input prices like corn and wheat. Transport companies use derivatives to hedge the negative impact they feel when fuel costs rise. In each instance, these industries are attempting to maintain viability by using derivatives, and require specific agreements with their counterparties which are designed for a very special situation.

Many investment firms like Pimco also participate in the derivatives market in order to lower or hedge a risk that their investors might be exposed to. Two common risks that these funds look towards reducing are interest rate risk and currency risk. A common derivative used to protect investors from rising interest rates or a depreciating foreign currency is called a “swap.” Swaps typically have very large nominal values, but the payments are often netted. Netting often results in the cash trading hands from the payer to the receiver in being a very small amount compared to the value of the swap on the books.

We would argue that when firms, financial or otherwise, use inexpensive and customizable derivatives to hedge their risk, this actually increases the stability and efficiency within the economy. Requiring derivatives to trade on an exchange could increase the cost of hedging techniques and reduce the customization that many firms rely on. The sheer size of this market, though, can be unsettling. In fact, the derivatives market is estimated to be valued at an unfathomable $600 trillion, while the entire world produces annual GDP in the range of about $60 trillion per year.

But it has always been the use of leverage, or debt, that has jeopardized our economy, regardless of what kinds of positions were leveraged and regardless of whether positions were purchased through a transparent exchange. It’s the lethal combination of risk and leverage that poses a systemic danger to the economy and, therefore, our investments. Regulating risk and the ability of a financial institution’s capital ratio is at the heart of preventing the next financial crisis and avoiding the next bailout.

But all signs pointing towards leverage in the system having been significantly reduced. Citigroup and Bank of America, forever beleaguered banks, have significantly stronger capital positions than they once did, although neither has shaken the malaise of the crisis. And the worst of the worst, AIG, is a shell of its former self after selling several business units and accepting a healthy dose of government capital.

Financials are not nearly as likely to get another crisis in the immediate aftermath of a generational event like 2008. And anyone who has tried to purchase a home or refinance a mortgage recently is likely to tell you that lending requirements are far more stringent than they were in 2007 – and probably more restrictive than at any time in the last 20 years. This anti-risk taking attitude extends to financial institutions’ willingness to participate in speculation through the derivatives market.

However, an institution might create a severe systematic risk to the greater economy if it were involved in serious amounts of speculation as opposed to hedging. For example, AIG wrote hundreds of billions of dollars worth of insurance on bonds that they never could have covered. Clearly, this action by an insurance company was a speculative business practice that should have been more vigorously regulated. This would be analogous to a bookie accepting numerous bets on one team without regard to his ability to pay and/or adjusting the spread as bets came in and/or laying off some of the exposure to another bookie.

In theory, the failure of AIG and the enormous bailout could have been avoided with some combination of additional and better regulation on the firms themselves. Good regulation of AIG could have encouraged or forced the company to limit their credit-default swap exposure to a sensible and affordable level.

There should be a distinction between firms that use derivatives to hedge risk as opposed to those trying to magnify risk. If “too big to fail” institutions are going to exist, it seems that simple capital requirements alongside vigorous oversight of the specific institutions are necessary regulatory initiatives. Higher capital standards alone would reduce the probability of these institutions from failing and, therefore, putting taxpayers in a no-win situation of paying for a bailout.

Simple, straight-forward risk reducing global regulation should be government’s initiative. It’s important to have global solutions to an evolving regulatory environment given the global nature of the economy and the investment landscape. If new rules are put into effect in just one jurisdiction, it seems unlikely to have an effect as transactions are sure to flow towards those jurisdictions with the lowest cost and the more favorable conditions for those parties entering into derivative contracts. Another question to consider is whether a firm is hedging their risk or using derivatives to speculate. Certainly, the firms involved in speculation pose a more significant risk and therefore deserve more regulatory attention.

Sue, I hope my answer above has given you some useful information regarding the derivatives markets. This is a very complicated matter, which is sure to spark debate for some time to come.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox

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