Author: George M. Bollenbacher
Associate Partner, Capital Markets Advisors
This July marks the fourth anniversary of the passage and signing of the Dodd-Frank Act, so it is appropriate to reflect on the two sections of the DFA most of interest to Tabb Forum members, Title VII on derivatives, and Section 619, the Volcker Rule.
Title VII
The first question we might ask about Title VII is whether swaps were really at the heart of the financial meltdown. Clearly AIG’s bailout captured the public’s attention, and the difficulties several municipalities had with IRSs were cautionary, but I would maintain that the role of swaps in the panic was much less than the real cause, the bursting of a massive credit bubble. Thus it is fair to say that the swaps market was a sidelight in the panic, albeit highly visible.
A much more important aspect of the swaps market, though, was its opacity. While the market size, as measured by notional, significantly overstates its risk, it is still highly dangerous to leave a large market like this largely invisible to the regulators, and even to its own participants. That danger is accentuated by the fact that the risk in this market is essentially double compared to, for example, the securities markets, because every position carries both market risk and counterparty risk throughout its life.
Reporting
So the biggest benefit of Title VII should have been the reporting requirement. If implemented properly, this requirement would have given the regulators, and to a lesser extent market participants, a real-time view of volumes, concentrations of counterparty risk, and even suspicious trading behavior. Unfortunately, none of these benefits have accrued, mostly because the requirement was badly implemented.
To begin with, the segment of the market which has the highest concentration of risk, single-name CDSs, still has no reporting requirement at all. Second, the product taxonomy is not functional, let alone mature, so that some of the highest risk areas – the various bespoke products – are lumped into an amorphous mass. Third, nobody appears to be checking the accuracy of the reported data, so we continually see trade reports that are obviously incorrect. Fourth, different jurisdictions have adopted different reporting methodologies, so nobody is sure on a worldwide basis which trade is which and how many are duplicates. Finally, trades where one counterparty is domiciled in a country with secrecy laws are purposely being mis-reported, with that counterparty’s CICI obfuscated. The bottom line is that reporting has yet to deliver on any of its promises.
Clearing
Lawmakers and regulators have trumpeted the clearing requirement as adding safety to the market, but that now looks less than certain. Most impartial observers recognize that mandatory clearing has served, and will serve in the future, to concentrate risk into a small number of entities. When you add the fact that the CCPs are in a competitive environment, you appear to get a formula for the next too-big-to-fail failure. Given that many of the users are not self-clearing, we have to add the complication and risk of the clearing broker or FCM, as MF Global and Peregrine have borne out. In a bilateral world, by contrast, each participant has a self-interest in performing due diligence, but the competitive clearing world introduces a whole new level of moral hazard, since trading firms will assume that someone else is doing the due diligence. The only benefit clearing could provide is the compression of many more positions than can be done bilaterally, and that benefit is diluted by the existence of competing CCPs in the same product.
The concentration of risk is accentuated by the attempt to regulate a global market locally. The widely reported disagreements between US and EU regulators about such things as the mutual recognition of CCPs serve as an early warning about what would happen in the demise of a CCP. Default waterfall arrangements are already pretty scary, but the inevitable finger-pointing among regulators if (or perhaps when) one of these CCPs goes down will only serve to increase the panic in the markets. So clearing is at best a wash, and possibly a significant negative.
Exchange Trading
Mandating exchange trading for certain classes of swaps was the third leg of this fairly wobbly stool, and it appears to be the weakest one. Since reporting was expected to give us a real-time view of trading activity, the only remaining reason to require exchange trading was price discovery. Every other financial market has evolved from a single execution method into a variety of methods, so it flies in the face of logic to force this one product, which is the least standardized of them all, into a single method.
And, of course, it won’t work. We have already seen market participants circumvent the simplistic exchange trading requirements by modifying start dates, so SEF trading in MAT product types remains a voluntary decision, as it should be. SEF trading really offers very little benefit for either market participants or regulators, and comes with a fairly high price tag, not only in exchange fees, but in infrastructure. To top it off, there is little evidence that SEFs provide any better price discovery than currently exists for MAT products.
Overall
If one were to do a cost-benefit analysis of Title VII from the public’s point of view, I suspect it would come out decidedly negative. Reporting had the most potential, but it is nowhere near working properly. Clearing serves to concentrate risk and increase costs through margin requirements and clearing fees, but it could create some benefits if it leads to the substantial closing of offsetting positions, as it has in the futures markets. If it doesn’t, it’s a significant negative. Exchange trading is a cumbersome solution in search of a problem, and its only saving grace is that the non-standard nature of the product makes it easy to avoid. All in all, not a sterling report card.
Section 619
If the justification for Title VII is clear – though disputable – the justification for the Volcker Rule is murky, and it shows in the rule itself. Economists and analysts may someday demonstrate whether or not the financial panic was due, in any significant way, to universal banking – or the combination of investment and commercial banking – but attempting to separate them by recreating Glass-Steagall in Dodd-Frank looks like making a watch with a hammer and chisel.
The first misfire is in the instruments excluded from the VR. Glass-Steagall itself applied to securities registered under the 1933 Securities Act, so it excluded Treasuries, agencies, and municipals. Whether that was good thinking in 1933 is debatable, but structuring the new version to regulate AAA corporate bonds while exempting Baa munis or Greek sovereigns doesn’t appear to make much sense.
The next misfire appears in the covered funds provisions. Apparently, the purpose was to prevent banks from circumventing the proprietary trading provisions by owning a fund that itself did proprietary trading. It turns out that this is much easier to envision than prohibit, so that the description of covered funds and the prohibited relationships between them and banks is a mishmash of circular reasoning and contradiction. If it achieves its objectives, it will probably be because banks abandon trying to understand the letter and simply go along with the spirit.
Proprietary Trading
In proprietary trading, while the structure of the rule is fairly straightforward, the implementation is anything but. The simple opening statement, that all proprietary trades in non-exempt instruments are banned unless they have an exemption, is understandable. But then we get to the exemptions, by which Congress abandoned any semblance of Glass-Steagall. Some exemptions are obviously part of commercial banking, like repurchase agreements, or the acquisition of an instrument through default on a loan where it was collateral. Even the liquidity exemption makes some sense – after all, if a bank would make a five year loan to a corporation, shouldn’t they be allowed to own its five year notes in their liquidity portfolio?
But wait … that example actually serves to point out the basic problem with the whole rule. Why would Congress and the regulators incentivize a bank to make an illiquid loan to a corporate borrower and disincentivize the bank from buying that same company’s tradeable notes? And the inability to answer that question renders much of the current discussion about the rest of the exemptions somewhat moot. But we should look at a couple of them anyway.
Market-Making
The market-making exemption will be the most difficult for the regulators to evaulate and enforce. Once a bank is established as a dealer in a non-exempt product, it will be impossible to tell whether they took a particular position in anticipation of customer demand or of market movement. The fact is, it doesn’t matter. If the bank follows good risk management practices, it’s immaterial which motivation applies to which trade. Any attempts to divine motivations, including some of the metrics that have been required, are simply a waste of time. And money, of course.
Hedging
Here there are some real benefits to the VR. The sloppy management of hedging in banks has led to some pretty spectacular losses, and some banks have characterized other blow-ups as hedging gone bad, whether they were or not. So the VR mandates some very good practices in hedging, such as:
- Hedging risks instead of positions or portfolios;
- Requiring correlation of the risk to the cause, and the hedge to the risk, all before the fact;
- Monitoring that correlation throughout the life of the hedge and correcting for changes; and
- Accounting for the hedge and the risk together and compensating the staff on the combined results.
If these provisions are incorporated into standard banking practices we will all be better off.
Overall
Once we get past the dubious logic of attempting to reinstate Glass-Steagall without actually reinstating it, we are left with some obvious conundrums. How can we let banks who act as asset managers own, promote and deal in the funds without being exposed to the risks of what the funds own? Why should banks be encouraged to lend money but not to own more liquid securities issued by the same borrowers? Once we have mandated good risk management practices, does it really matter whether the same exact position was taken in anticipation of market movement or customer demand?
Looking Forward
All right, so these parts of the Dodd-Frank Act and their implementation are sub-optimal to say the least. So what? The question is how do we make the best of it? A few humble suggestions:
- As much as the financial markets are being transformed, the markets for financial services are also being transformed. Coming out of the current chaos will be a set of winners and losers, and the winners will have looked past the problems to the opportunities. This will require letting go of some practices that worked well in the past, sort of like jumping from the dock to the boat before it’s too late. The exit of several firms from the clearing space because they couldn’t make the business model work is an early example.
- The new requirements have prompted firms to streamline their operations and technology, some of which were dangerously outdated. As technology firms scramble to respond to the evolving marketplace, for example, the overall efficiency of their products will inevitably improve.
- Intrusive regulations mean intrusive regulators – they’re only doing their job as well as they can. The problems in reporting hamper surveillance, of course, and in many cases they are as much at sea with the regulations as the banks are, so the regulators will probably look more kindly on those banks who are trying to cooperate than those fighting city hall.
- Given the current relationships between the regulators around the world, regulatory arbitrage will be a thriving business for a long time. Global banks and their global customers will become very adept at this, and local institutions of both types will just have to live with the cards they are dealt.
In another four years most of the current uncertainties will have receded, and a new order will be established in the markets. The winners will be reaping the rewards of their very hard work, the losers will be hanging on or gone from the scene, and everyone will be busy making money again. Unless, of course, we have another meltdown in the meantime.
