Derivatives: The Risk That Still Won’t Go Away

Greenspan has since said he’s sorry he opposed regulation of derivatives; Summers, now economic adviser to the President, has signaled his recantation by joining Geithner in calling for strong regulation; Gramm, no longer in the Senate, would not comment to Fortune. The ranks of the converted, however, have been swelled by no less than former President Bill Clinton, who recently told New York Times writer Matt Bai that he was wrong in listening to Greenspan about derivatives and wishes he had demanded that they be regulated by the Securities and Exchange Commission.

Early Warner. For her efforts a decade ago to bring derivatives into the regulatory tent, Brooksley Born just won a “Profile in Courage” award from the Kennedy Library

Today, the chances for regulatory reform are improved because the administration has made it a top priority, and two powerful legislators, Congressman Barney Frank (D-Mass.) of the House financial services committee, and Chris Dodd (D-Conn.) of the Senate banking committee, have signed on. The administration’s plan calls for new regulation of “systemic risk” and envisions the Fed shouldering most of the job. In that role, the Fed would have czarlike authority to move in on trouble spots wherever they flared up, including derivatives sites—like an AIG—that aren’t part of the banking system.

While believing the Fed the best candidate for this role (best athlete, as headhunters say), Bob Steel, the former Treasury official, calls the regulation of systemic risk a “next to impossible job.” Essentially, it requires someone to be risk manager for the entire United States (and also be cleverly attuned to world risks, of course), when individual companies have shown repeatedly that they are incapable of managing the risk right under their noses. Suffice it to say that AIG believed for years, until the roof fell in, that those CDS it wrote were money-good.

A Treasury colleague of Steel’s, David Nason, now a managing director of Washington’s Promontory Financial Group, joins him in believing that the challenge awaiting a systemic regulator will be extraordinary. But Nason says there is no question where this regulatory eye in the sky will fasten its attention: on all the interconnections between institutions. And here, he says, derivatives—“highly complicated, specialized, using their own language”—are ground zero.

That means there must be new regulations for OTC derivatives. Naturally the dealer community will resist, since it believes that operating out of direct sight—in the Dark Market, as Born called it—is best for profits. But since the dealers judge some degree of regulation inevitable, their strategy is to hold it to a minimum.

That leaves them not raising Cain about today’s conventional wisdom, which is that “standardized” contracts—for example, five-year, $10 million CDS on a well-known company—must be moved into a clear­inghouse. This organization would, first, set capital and margin requirements for its members. Second, it would become the creditworthy counterparty for both the buyer and the seller in every contract submitted for clearing.

But clearinghouses have their own drawbacks. Were there a financial megashock, for instance, some clearinghouse members could be weakened to the point of defaulting on their contracts with the clear­inghouse, whose reverses would in turn threaten the stability of other members. Former regulator Corrigan is one expert respecting this risk: He says that if a clearinghouse is to be a financial Gibraltar, it needs sufficient resources to withstand a simulta­neous default by two of its biggest members! That would equate to, say, J.P. Morgan Chase and Bank of America going bust. The mind reels at the thought.

The big derivatives dealers, in any case, do not expect to find much use for clearinghouses. They will be asserting in any debate that there are just about enough standardized contracts to fill a thimble and that the big sewing-box of derivatives mainly produces customized—or “bespoke”—contracts that couldn’t possibly be handled by a clearinghouse. In response, the administration is calling for all customized derivatives to be reported to a central repository and for the systemic regulator to have the authority to peer deeply into the derivatives book of any individual company.