Best Securities Reform Proposal

I am kicking myself that I didn’t come up with the proposal made by Brandeis professor Stephen Cecchetti in today’s Financial Times. His opinion piece, “A better way to organise securities markets,” is the single best idea for securities reform I have seen in a very long time. It is simple, elegant, and addresses many of the problems we are facing now. It also doesn’t have to be implemented at once, but is an objective regulators can work towards over time.

So what is this great idea? Force as much financial trading as possible on to exchanges.

What problems does this proposal solve? Some of the biggest ones we see now, namely transparency, worries over counterparty risk, and regulatory oversight. Keep in mind that the troubles in the markets are happening solely in what are called over the counter markets, like the credit markets, where investors buy and sell from various dealers and the dealers trade among themselves.

While information services like Bloomberg operate in many of these markets, allowing dealers post prices on instruments they trade. However, these are indicative prices, typically on the more liquid instruments . You need to call the dealer to see what the price is on the amount of you want to buy or sell. And once you’ve done the trade, only you and the dealer know the price and size. Thus in these markets, there is considerable ignorance on very basic parameters, such as overall trading volumes, ownership, etc. The only way to get it would be to aggregate it across dealers, a monumental task for regulators even if they have the authority to compel the dealers to cooperate (worse, regulatory authority tends to fall along industry lines, say bank versus securities firm, rather than by instrument. Thus who has authority over, say, credit default swaps is muddy indeed).

Now that isn’t to say this process would be easy. In fact, the OTC incumbents will fight it tooth and nail since OTC trading, managed well, is very profitable (except in a down market when market makers find themselves taking sizable inventory losses). It would also gut the investment banks’ profitable prime brokerage business (the exchanges would have margin requirements; investment banks could selectively provide additional leverage to hedge funds, but this would be a smaller and riskier activity. Note that the new exchanges would presumably be owned by the old OTC dealers, but owning a part of a utility is likely to be less attractive than the current regime. Greater transparency generally means lower profits).

In addition, a few markets, such as the commercial paper market, don’t have secondary trading (commercial paper is placed and investors hold it to maturity) and thus will not fall under this regime.

Nevertheless, Cecchetti’s idea is a goal regulators can pursue. For example, they can put measures into place that require new investment and hedging vehicles to be traded on exchanges. And if there were to be a real crisis, which would inevitably lead to calls for tougher rules, this sort of proposal, of greater regulation of markets, would probably be regarded as more attractive than more comprehensive control and oversight of the institutions themselves.

Another development favoring Cecchetti’s recommendation is that the investors themselves are becoming harder to supervise. Making the markets more transparent is an important counterbalance. As Thursday’s Financial Times reported:

Global financial markets face a permanent shift in power from traditional money managers to opaque groups such as petrodollar investors, Asian central banks, hedge funds and private equity groups, according to a study out today.

These power brokers had amassed $8,400bn in assets by the end of 2006, three times what they held in 2000 when they were “little more than fringe players” in the capital markets, says the report, published by McKinsey Global Institute

Their holdings now represent 5 per cent of the world’s $167,000bn of financial assets. If current trends continue, they could control assets worth $20,700bn, or nearly three-quarters of the size of global pension funds, by 2012.

However, the study says the four investor groups often lack transparency and are out of the reach of regulators.

“It is true that there is not the kind of light shed on some of these activities in the way we are used to,” said Diana Farrell, director of MGI and one of the authors of the report.

“The Anglo-Saxon model of capitalism will be challenged. We need to evolve in terms of regulatory oversight.”

From Stephen Cecchetti’s article in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.

After LTCM’s collapse, people thought hard about the structure of financial institutions. What information disclosure should be required? What rules should officials implement to ensure that an institution’s failure does not put the entire system at risk?

But the recent turmoil suggests we should think again. Comparing 1998 and 2006 suggests that this time we should look for lessons about the way securities markets are organised.

The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations. In organised exchanges, the clearing house insures that both sides of the contract will perform as promised. Instead of a bilateral arrangement, both buyers and sellers of a security make a contract with the clearing house. Beyond reducing counterparty risk, the clearing house has other functions. The most important are to maintain margin requirements and “mark to market” gains and losses. To reduce its risk, the clearing house requires parties to contracts to maintain deposits whose size depends on the contracts. At the end of each day, the clearing house posts gains and losses on each contract to the parties involved: positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the role that capital requirements play for banks. Marking to market offers a way to monitor continuously the level of each market participant’s capital.

Finally, exchange-traded securities are standardised, creating transparency: buyers and sellers know what they are buying and selling.

Returning to the comparison of Amaranth and LTCM, we can see why the former did not provoke concerns of a systemic crisis. Amaranth was required to hold margin to maintain its position in futures markets. When it started to sustain losses, the clearing house forced the sale of the positions into a liquid market; counterparties sat calmly, knowing their interests were protected. By contrast, the swaps LTCM held were with specific institutions. Since interest-rate swaps are not exchange-traded, selling them was not feasible. The collapse of LTCM would have led to defaults on the contracts and put other financial firms at risk.

This brings us to the present crisis. The defining feature is that there are securities out there no one knows how to value. We discovered this when potential investors refused to accept certain mortgage-backed securities as collateral in the issuance of commercial pap er. A failure of investors to monitor the originators of these securities had led to the creation of complex and non-transparent securities. If these were ex change-traded through a clearing house, these problems would largely disappear.

There are many ways to encourage people to move trading into clearing houses. Are there tax and regulatory incentives that are doing the opposite? Are banks, insurance companies and pension funds being rewarded for holding difficult-to-value securities that are not exchange-traded?

The goal is to structure financial markets in a way that minimises system-wide risk. Yet we also need to remember that there are gains to asset-backed securitisation. When the system works, it turns illiquid bank loans into readily marketable securities. This should reduce the overall riskiness of the financial system. Shifting these securities to exchanges with clearing houses would help ensure that these benefits materialise.

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  1. Anonymous

    Good idea, but only in theory. The exchanges are a good solution for liquid, well traded instruments. eg. the NYMEX Henry Hub gas futures traded by Amaranth. But those instruments are not a problem to begin with. The genesis of August swoon are the illiquid instruments- CDO tranches, CLO’s etc. which are unique and are not held by large/diverse groups. Thus there is lack of liquidity/volume/bids/asks. The problem remains- what’s the value of a particular security, how much margin should be posted against them (needs to be calculated each day) and is the margin enough to protect the counterparty. It is the same reason why corporate debt is not traded on exchange- too many different structures even for the same company.

  2. Anonymous

    Exchanges are creations of regulation (SEC), so there will need to be significant discussion about who you want into these exchanges for more esoteric products, and how you would force an organization to use an exchange, rather than enter into one-on-one transactions. Sounds good in theory, but the regulatory organizations and certain laws have to be restructured.

  3. Anonymous

    I agree with 10:38 – trading non-transparent securities on an exchange will only marginally improve liquidity. That said, has anyone studied the effect of the new, unregulated 144A exchanges? It’s very possible that they do provide some benefits.

  4. Yves Smith

    I don’t see the main benefit of having regulators push where possible for more trading via exchanges being an improvement in liquidity. I see it as being an improvement in transparency, that trade prices and volumes will be a matter of record. This will give the regulators vastly more insight into what is going on in these markets.. It will also transfer risk-bearing away from private institutions which are in multiple lines of business to entities that are adequately capitalized for the trading activities that happen through them. That has the secondary benefit of limiting the damage that can be done (and hence the cost of salvage) of institutions that are “too big to fail.”

    As for Anon of 10:38, I agree there are considerable practical obstacles. However, the issues you raise about margin on exchanges apply to the same degree to margin lending provided by prime brokers against these very same instruments. If PBs can lend against the, exchanges could too. And conversely, if the issues are so insurmountable that they aren’t appropriate for exchange trading on margin, that begs the question of how the securities firms can be doing it properly and prudently.

    As for corporate bonds, my impression as to why they aren’t exchange traded is somewhat different. Historically, they were pretty much never traded (investors held them to maturity) so there was only occasional demand, which was satisfied by bond trading houses. Now with modern order-matching systems, if an investor was patient, he could post a price at which he’d be willing to buy or sell and see if anyone hit his bid.

    There was serious interest in that sort of system being launched on a utility basis, a de facto exchange, in 2000-2001 (I know some of the people involved). But it seems to have been made irrelevant by the fact that investors instead used credit default swaps as a proxy for cash bond trading.

  5. Anonymous

    Yves- PB’s have the tools to value illiquid instruments and lend against them- after all they structured them. Exchanges do not.

    Anon- 10.38

  6. Anonymous

    In other words there have never been “liquid” markets in these securities, so liquidity cannot solve the problem. You merely had consensus on valuation which appears now to have gone away because the underlying asset performance is unstable. Holders might still dislike prices offered on an exchange.

  7. Yves Smith

    Anon of 10:38 AM,

    My impression is that Cecchetti is talking about new exchanges that trade specific types of instruments.

    There is no inherent reason why an exchange can’t value a contract. In fact, it ought to be able to have better information by having all the trading in a type of instrument flow through it, rather than only a slice of the market.

    The reason the PBs have a leg up now is that they have or can get the deal documents. Even the regulators can’t obtain them (the excuse being that they aren’t qualified investors. I think the Fed’s New York desk ought to set up a hedge fund to solve this problem. Of course, legislation could do that too). Under an exchange scenario, the terms of all traded instruments would be public.

    Anon of 4:17 PM,

    Exactly, Liquidity is not the main reason (in my mind) to try to require more trading to take place on exchanges, but improved oversight. You will not create more natural buyers or sellers.

    It is possible you will see more liquidity by virtue of lower and more explicit transaction costs (investors feel better about trading if they don’t have to worry about being raped on the trade).

    Another factor that might improve liquidity is standardization of contracts and structures, which would make the instruments more fungible. But as I said, I wouldn’t count on them.

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