Showing posts with label credit default swaps. Show all posts
Showing posts with label credit default swaps. Show all posts

Friday, June 14, 2013

In The News: Swaps and Naked Shorts

A flurry of recent events suggest that many of the provisions of the Dodd-Frank Act are finally being implemented by rule or coming of age. The June 11, 2013 edition of the Wall Street Journal lays out some perfect examples of the regulatory ripple effect of the 2008 financial markets meltdown.

I still recall happening upon a discussion between a securities regulator from Vermont and a securities regulator from Utah during the early months of my tenure as Commissioner of Securities. The two of them were discussing “naked shorts” and I initially thought I was interrupting a private discourse. Luckily, I stayed around long enough to learn about a stock option practice—now restricted—that can be used as a legitimate equity market hedge strategy or abused as a market manipulation strategy.

The Wall Street Journal reported on page C-1 that a SEC administrative law judge had ruled against a former Maryland banker in finding him liable for “naked short selling.” As you probably know, a short sale is accomplished by selling stock you don't own by borrowing it from someone who is “long” in the stock (owns it). The goal is to buy the stock back out of the market if and when the stock’s price goes down, and return the new shares to the original owner. For example—if you sold the borrowed shares for $10 and bought the replacement shares for $5, you made a nice little profit. “Naked” short selling distorts the market price of the shares because the shares being sold were never actually borrowed. This does damage to current shareholder's because it creates a negative downward market pressure on the price of the stock at issue.

The SEC judge in the case also ordered a brokerage firm owned by Charles Schwab to disgorge $1.6 million in profits and pay a $2 million fine. The judge even went so far as to bar the firm's former CEO from the securities industry. It seems the brokerage turned a blind eye towards the banker's failure to clear his short sales.

Along the lines of new and tighter restrictions mandating timely clearance, the same edition of the Wall Street Journal has an article about the new rules that recently took effect regarding swaps. A swap is a “derivative” of an actual equity. Reporter Katy Burne Succinctly explains that:

“Derivatives allow users to protect against everything from moves in interest rates to the cost of raw materials, and swaps are more-complex derivatives that have generally been traded away from exchanges. As of Monday, more are being routed to central clearing houses, which take fees to guarantee trades in the nearly $650 trillion global swaps market. The 2010 Dodd-Frank financial-overhaul law mandated that many swaps be cleared in an effort to help prevent a financial system meltdown by forcing traders to post collateral known as margin. When Lehman Brothers Holdings, Inc. failed in 2008, just a fraction of its multitrillion-dollar swaps book was cleared. Lehman's failure sent shock waves through financial markets and accelerated a general pullback by investors from riskier investment classes.”

I can't say it any better than that.

The same edition covers the rating agencies’ new-found “lack of sway” (loss of credibility) since they fell in love with and heaped AAA ratings on mortgage-backed collateralized debt obligations that were packed with junk. Journalists Nicole Hong and Carolyn Cui, however, attribute the diminished influence to factors such as “the prominence of global economic factors driving bond prices” (as opposed to the intrinsic credit soundness of the bond issuer I suppose). Finally, the edition at issue ran a story about another child of the Dodd-Frank Act—the Bureau of Consumer Financial Protection—scrutinizing bank overdraft fee practices. And it is about time on that score.

In sum, if you missed the Wall Street Journal on June 11, 2013, you are lucky you found this blog. Food for thought.

Thursday, March 4, 2010


On March 1, Commodities and Futures Trading Commission (“CFTC”) Chairman, Gary Gensler, spoke to the Institute of International Bankers about over-the-counter (“OTC”) derivatives reform. On March 2, he spoke before the Women in Housing and Finance organization. In his addresses, Mr. Gensler discussed the history of derivative markets, the need for comprehensive regulation in these markets, and the regulatory reforms that should be implemented. The CFTC is charged with monitoring and regulating the futures and commodity options exchanges in order to protect market participants and promote fair trading.

In 1981, the first derivatives transaction took place. Throughout the 1980s, these instruments were tailored one at a time to meet specific risk management requirements of two sophisticated parties—usually a dealer and a corporate customer. Parties negotiated a deal each time they needed to hedge a specific financial risk; they were not widespread public investment tools. Because these transactions did not take place on regulated exchanges, but rather existed purely in company accounting books, the information available to the public about pricing was not readily available. Further, this lack of information made it difficult to understand the magnitude of interconnectedness between financial institutions. Over the next decades, the notion of derivatives as a hedging tool became increasingly popular, causing contracts to be more standardized and easier to negotiate and trade. Upgrades in technology further influenced the popularity of derivatives by facilitating easy electronic trading. At its peak, before the financial crisis, the derivatives market had a notional value of $300 trillion in the U.S., whereas in the 1980s, the notional value of the derivatives market was only $1 trillion.

Since their inception, these financial hedging tools remained largely unregulated. In the aftermath of the financial meltdown, it became known how OTC derivatives can increase risk when unregulated, instead of functioning properly as a risk hedger. Their risk-added is even more dangerous when coupled with the limited availability of pricing information and a lack of transparency. It is for these reasons that Chairman Gensler advocates comprehensive reform of OTC derivatives.

According to Chairman Gensler, there are three main components that will result in effective reform:

  1. Explicitly Regulate Derivatives Dealers
  2. Implement Transparent Trading Requirements
  3. Organize Clearinghouses to Clear Standard Derivatives

Derivative Dealer Regulations. Chairman Gensler believes that having an explicit regulatory framework of derivatives dealers will lower risk. First, the regulations should impose certain capital and margin requirements to mitigate risk to the public. Second, business conduct standards should be put in place to protect against fraud, market manipulation and abuse, which will in turn promote market integrity. Finally, derivatives dealers should have standardized recordkeeping and reporting requirements. Such requirements would bring transparency to the system and provide more accurate pricing information to the public.

Transparency in Trading. Chairman Gensler asserts that trading must be transparent in order to improve how current markets function, create better market liquidity and lower hedging costs. In order to have trading transparency, he advocates that there must be centralized trading venues. These venues would be better equipped to asses and manage risk of OTC derivatives and provide transparency because all derivatives trading would have to have cleared positions based on a reliable market price. The reliable market price would be a by-product of having central trading venues.

Central Clearinghouse for Standard Derivatives. Currently, derivatives are primarily listed on company books, not with a central source, which creates unknown levels of interconnectedness between financial institutions and contributes to the issue of “too big to fail.” Therefore, Chairman Gensler believes that it is imperative to have a central clearinghouse to understand how institutions are connected, because a central clearinghouse would provide transparency about these relationships and reduce interconnectedness of banks since derivatives would flow through the clearinghouse instead of bank balance sheets. It is estimated that 75% of derivatives traded are standard derivatives transactions. Such transactions, because of standardization, can therefore be monitored and cleared though one central clearinghouse. Those derivatives transactions that are highly specialized and tailored would remain outside the scope of the clearinghouse (but within the dealer regulations) and would still be allowed to trade bilaterally. Further, Gensler concedes that there would be other exceptions, but exceptions should remain narrow and explicit.

In closing, Chairman Gensler reiterated the necessity for OTC derivatives regulations because “the central lesson from the crisis is that an interconnected financial system facilitates the spread of risk from institution to institution, threatening the entire economy.”

Currently, the House of Representatives is considering H.R. 3300, the Derivative Trading Accountability and Disclosure Act, which would implement many of the changes Chairman Gensler suggests. The Senate also introduced Senate Bill 3714, Derivatives Trading Integrity Act of 2008, which focused primarily on introducing a regulated exchange for certain types of derivatives. However, that bill was never reconsidered.