Derivative trades dont all belong on exchanges

Derivatives regulation should seek to foster a sound,competitive and
liquid marketplace,while preserving the flexibility for market
participants to hedge risks.

TWO years after the onset of one of the worst financial crises since
the Great Depression,the US Congress continues to grapple with
the overhaul of the financial regulatory structure.
We can all agree that system-wide reform is necessary to protect
American taxpayers and to ensure a safer,stronger and more
efficient marketplace.However,regulatory reform is a complex
undertaking and should not be used as the latest venue for political
theatre.It is far more important to get this done right than to race
blindly toward an artificial deadline simply to get it done.
Providing a framework for the regulation of the over-the-counter
(OTC) derivatives market is a key component of any comprehensive
reform bill.The Congress is currently considering several proposals
that each provide important steps to address transparency and
potential systemic risk in the OTC market.
These steps include reporting of trades,increased opportunity for
clearing,sufficient cushion in the form of risk-based margin or
collateral,heightened capital requirements,as well as detailed market
participant record keeping for ongoing regulatory review.
All of the current proposals,however,go one step too far by
mandating that trades of these complex financial risk-management
tools be executed through an exchange.Such a requirement would
result in significant and harmful economic costs without providing the
intended safety and soundness benefits.

LIQUIDITY RISK
A central problem of mandating exchange trading is the potential
market liquidity risk that will accompany it.
During 2008 the world was reminded that liquidity problems,though
typically infrequent,are high-impact events.Liquidity risks are
commonly interpreted as cash or funding risks,but market liquidity
also represents the ability to execute transactions.Congresss aim
for OTC regulation is to reduce systemic risk to the financial system
by,at the very least,providing an efficient regulatory structure that
reduces the frequency and severity of market liquidity problems.
By and large,the swaps market is a wholesale,institutional market
where most trades are large,block-sized transactions.Mandatory
exchange trading will reduce market liquidity and increase execution
costs for the ultimate end-user of these swaps.Advocates for
mandated exchange trading want to decrease bidask spreads,which
will theoretically lower the cost of these products,but they fail to
understand the market sensitivities.

SWAP PRICING EFFECT

Mandating real-time dissemination of swap transaction price and
quote data will require market participants to announce their trading
interests to the entire market and allow others to step in front of
their trades,moving the market against their hedges.In such an
environment,market liquidity for swap transactions will decrease
dramatically,if not disappear altogether.
Both the UKs Financial Services Authority and the Committee on
Capital Markets Regulation in the US recently came out in support of
policies that promote the movement toward exchange trading,but not
an explicit government mandate.Even CME Group,the worlds largest
futures exchange operator,has communicated to the Commodities
Futures Trading Commission that while some swap transactions are
standardised enough to be tradable,others are not,and industry
migration toward exchange trading is more appropriate than a
mandate.

THE RIGHT REGULATIONS

As we move forward in our reform efforts,I hope my colleagues will
keep in mind the important role derivatives play in our
markets.Derivatives regulation should seek to foster a
sound,competitive and liquid marketplace,while preserving the
flexibility for market participants to hedge risks.
However,if Congress does not remain focused on these worthwhile
aims,we will unintentionally create global regulatory arbitrage and
the flight of capital to less-regulated jurisdictions overseas.Such a
one-size-fits-all mandate will draw capital away from the United
States,reduce innovation and job creation,and do fundamental harm
to our free market economy.