Why Derivatives Market Reform Means So Much
How should derivatives be reformed in the wake of the financial crisis?
- The diminution of the earnings of Wall Street's largest firms would be a sign of progress and productivity.
- Today, Wall Street and the City of London sit at the apex of the economy — not unlike the automotive companies did nearly 40 years ago.
- Financial institutions are a means to an end, rather than an end in themselves.
- Derivatives are not a minor dimension of U.S. or international capital markets. They occupy a dominant position.
- The outstanding notional amount of derivatives stood at over $454 trillion in mid-year 2009.
The intersection between "too big to fail" financial institutions and over-the-counter (OTC) unregulated derivatives is the equivalent of the San Andreas Fault of our financial system.
We are in a new era where the size of the capital markets and their derivative instruments are a dominant dimension of the intermediation of credit. Therefore, the transparency of derivatives is essential to the safety and soundness of our financial system as a whole — and it is essential to the protection of the public treasury.
Without OTC derivatives reform, enhanced resolution powers for dealing with insolvent institutions could well be rendered impotent, and future crises in the credit allocation system will likely be longer and deeper than is necessary.
We have a financial architecture in place governing derivatives that has failed profoundly. The bailout costs, lost output around the world and breathtaking rise in unemployment are the result of that financial failure.
If a dysfunctional derivatives market has led to overuse of derivatives throughout the financial system. It has also made them too cheap to use because provision for the integrity of the system was not built into the costs, which, in turn, means it is imperative to improve that system architecture.
The resulting system — fortified, more transparent and better regulated — would reduce the likelihood, and magnitude, of a recurrence of a financial calamity. Society would be better off with lower unemployment.
Derivative contracts have become an enormous proportion of the total notional credit exposure in U.S. and world financial markets. According to the International Swaps and Derivatives Association (ISDA) survey, the outstanding notional amount of derivatives stood at over $454 trillion in mid-year 2009.
The Bank for International Settlements puts the number at nearly $800 trillion worldwide. Using ISDA data, that is over 30 times U.S. GDP. According to the flow of funds data from the Federal Reserve, total credit market debt outstanding is just under $53 trillion. Derivatives are not a minor dimension of U.S. or international capital markets. They occupy a dominant position.
Most importantly, the institutions that were at the core of the crisis and controversial bailouts in fall 2008 are, at the same time, the dominant institutions in the OTC derivatives market.
In fact, according to the Office of the Comptroller of the Currency, the top five institutions in terms of derivatives exposure — Citigroup, J.P. Morgan/Chase, Bank of America, Morgan Stanley and Goldman Sachs — hold over 95% of derivatives exposure of the top 25 U.S. bank holding companies, of which 90% is OTC. This is why I call this the financial equivalent of the San Andreas Fault.
Our "too big to fail" institutions, the same ones that have relied on the support of the public treasury in the crisis, are the dominant market participants in the OTC derivatives market. As a result, U.S. taxpayers have a very strong and direct interest in how the derivatives markets are structured and regulated.
A natural consequence of improving transparency and information on pricing is that the intermediaries who dominate the market will see lower profit margins and a somewhat lower volume of transactions. The negative impact on earnings of the top banks, which have made more than $15 billion in the first half of 2009 from derivative trading, is likely to be significant.
Brad Hintz, a financial analyst at Sanford C. Bernstein and Co., estimates that proper derivative reforms could reduce the earnings of large institutions by 15% by moving to clearinghouses — and even more if transactions were moved to exchanges.
However, making markets more efficient at lower costs is desirable from a social point of view. Financial institutions are a means to an end, rather than an end in themselves. Legislation to improve the efficiency of the market system improves the productivity of society — and, if at the same time these market structures are repaired to be less vulnerable to crisis, it is also of great social value.
The diminution of the earnings of Wall Street’s largest firms would be a sign of progress and productivity. Efforts to resist the transition by Wall Street firms, while understandable, are harmful to society and the economy on the whole.
In 1970, the U.S. automotive industry was at the apex of the world economy. Yet, for many years thereafter, the automotive industry struggled to adjust to the new realities of global commerce. Executives from the Big Three spared no effort of time, money or energy to plead with the U.S. Congress to relax social policy requirements regarding fuel emission standards rather than devoting their energy and resources to R&D directed at improving their products.
The result was that together, the auto industry and Congress produced a failure that is all too evident today.
Today, Wall Street and the City of London sit at the apex of the economy, not unlike the automotive companies did nearly 40 years ago. It is my hope that our nation will resist "helping" Wall Street adjust in the destructive way they enabled the auto industry to avoid modernization.
Wall Street spent many years in public discourse thwarting and resisting the appeals for protection from the declining manufacturing sector. Is it too much to ask them now to practice what they have preached to other sectors of the economy repeatedly?
I am confident in the intelligence and vitality of the men and women who work on Wall Street today. They are very able and do not need "Wall Street Protectionism" to survive and to thrive.
Would it not be better to inspire them, particularly in light of this crisis, to adapt to a more vital market system — rather than to acquiesce to their demands to perpetuate a system that protects their profits at the risk of exposing society to a danger to the integrity of our financial system that has caused so much hardship in the present and recent past?
Adapted from Robert A. Johnson’s testimony before the U.S. House of Representatives Committee on Financial Services on October 7, 2009.