How Botched Derivatives Risk Taming Regulations are Again Going to Leave Taxpayers Holding the Bag

An important piece in the Financial Times by Manmohan Singh, a senior economist at the International Monetary Fund, describes persuasively how one of the central vehicles for reducing derivatives risk, that of having a central counterparty (CCP) and requiring dealers to trade with it rather than have a web of bi-lateral exposures, or rely on banks to act as clearers (making them too big to fail) has gone pear shaped. While the immediate reason for this outcome is the unwillingness of national banking regulators to cede powers to an international clearinghouse, Singh fingers an equally important cause: the reluctance to recognize that the underlying problem was and remains undercollateralized derivatives positions. His introduction to the mess:

Little progress has been made on crisis resolution frameworks for unwinding large banks, let alone huge new institutions called CCPs that would house trillions of dollars in financial derivatives. Thus, the underlying economics of having more “too-big-to-fail” entities needs to be justified.

Financial statements show that each of the large banks active in the OTC derivatives market in recent years carries an average of $100bn of derivative-related tail risk; that is, the potential cost to the financial system from its collapse after all possible allowable “netting” has been done within the bank’s derivatives book and after subtracting any collateral posted on the contracts. Past research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5tn in under-collateralised derivatives liabilities, a cost taxpayers may have to bear unless some solution to the “too-big-to-fail” question can be proffered.

Housing derivatives in one single global CCP backstopped and regulated by the leading central banks would have been an ideal “first-best” solution as it would enhance netting, reduce collateral cost and “house” overall risk in one place. A “second best” solution would have involved a few linked CCPs scattered around the globe. However, local politics has resulted in the least-best outcome. A plethora of CCPs are being created because countries such as Australia and Singapore do not want to lose oversight to an overseas entity incorporated in a foreign country.

Singh also mentions that any implementation of a CCP scheme should result in less re-using of collateral (and the main use for collateral is securing over-the-counter derivatives positions). Dealers already are planning to vitiate that outcome, as we discussed last month:

More obviously troubling was a Bloomberg story on how major financial firms are going to undermine the effectiveness of clearinghouses by engaging in “collateral transformation”:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Understand what is happening here: clearinghouses are one of the major elements of Dodd Frank to reduce counterparty risks. But the banks are proposing to vitiate that via this “collateral transformation” which will simply create new, large volume counterparty exposures to deal with fictive clearinghouse risk reduction program. And get a load of this:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment

Translation: the regulators are aware of the banks’ plans to finesse the clearinghouse requirements, and they neither intend to put a kebosh on it (which could easily be done by taking the position that any collateral transformation to meet clearinghouse requirements was an integrated part of the clearinghouse posting and could not be done separately on bank balance sheets) nor understand the impact of their flatfootedness.

This massive fail results from the refusal to deal with the derivatives problem head on.

Back to the current post. Singh draws the obvious conclusion:

The result could be more, not less, moral hazard. In the most extreme scenario, a temporary liquidity shortfall at any of these CCPs would immediately cause systemic disruption. It is likely central banks, and governments, would have to give whatever support was necessary at taxpayers’ expense. In essence, this is a roundabout way for derivatives risk to be picked up by taxpayers.

Singh proposes an elegant solution: taxing derivatives liabilities. What is simply not discussed enough in the post mortems of Lehman is that the reason the losses were SO large was because the derivatives liabilities blew out when markets got roiled. I’ve had savvy readers (in particular Hubert, but he’s not alone) puzzle again and again over the Lehman financial statements, unable to get to the total losses by haircutting the assets on the balance sheet. That’s because that was only one of Lehman’s problems. Remember, under the 2005 bankruptcy reforms, counterparties to derivatives trades can grab collateral first and be asked questions later. Having again and again looked at the size of the Lehman black hole, it’s clear that overstated assets and the additional losses resulting from the “disorderly failure” of the firm (estimated at $50 to $75 billion by the official minders; people on the other side of the table put it at more like $30 billion) don’t come close to explaining the shortfall. The gap is due to the crisis-induced increase in derivative liabilities. So this is not a theoretical risk; this was a big part of why Geithner decided to become “bailouter in chief” as the most expedient remedy.

So a tax on derivatives liabilities would curb the very sort of “heads win, tails you lose” risk-taking that is likely to get dumped on taxpayers eventually, by squarely addressing a major source of systemic risk that regulators have been all too cautious in addressing. It would leave it up to the banks to decide how to adapt to a regime that would force them to price derivatives as if they were adequately collateralizated. Singh again:

A levy on derivative liabilities is a more transparent approach given that the costs to bail out CCPs will ultimately fall on taxpayers. If the levy is punitive enough, large banks will strive to minimise their derivative liabilities, which could eliminate the systemic risk in the derivatives market should a large bank fail. This proposal addresses the source of the problem – under-collateralisation in this market – and does not bury it in technical jargon such as SEFs, FCM, DCM, DCO, DCE, MSP, LEI, portability, interoperability, non-cleared trades and extraterritoriality. The levy will force banks to take (and give) collateral with clients when it is due on the derivatives.

Also, some by-products of the levy will be most welcome. First, a fund from levy revenues could be used to bail out banks that prefer to keep OTC derivatives on their books and thus pay the levy. Second, when all derivative users including sovereigns post their fair share of collateral, banks will not need to hedge positions where they are in-the-money but with default risk. Demand for hedging leads to higher credit default swaps spreads that may increase the cost of debt issuance. The CCP proposal that regulators are so enamoured with is a sleight of hand that instead of resolving the “too-big-to-fail” problem deflects it back to taxpayers.

This sort of tax is philosophically similar to the one that Lee Sheppard advocated on high frequency trading, set at a level that is high enough to discourage socially undesirable outcomes. While these reform discussions are still, sadly, all theoretical, it’s important to have simple, effective remedies ready when opportunities arise to curb banks’ power.

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  1. YankeeFrank

    I have to wonder what will happen the next time taxpayers are taken for the proverbial ride, because its coming, probably sooner rather than later. Will we all sit on our hands again or will we do something to stop it? No doubt it will be obfuscated and the Geithners of our world will try to hide the bailout behind walls of bullshit. We shall see.

  2. jake chase

    Every estimate of derivatives exposure is probably understated by a factor of 1,000. Derivatives trading has no other purposes than gaming accounting rules, increasing bonus pools and enabling looting. When the music stops all the assets disappear. The truest words ever spoken by Warren Buffet (who has told more than his share of whoppers) called these ‘financial weapons of mass destruction’.

    1. Can't Help It

      Got gold :) The money is not the issue, but once confidence in the system is lost, it’s probably neanderthal time. As for Buffet, I always pray that he has a long life so that a time will come when the S&P 500 puts he sold (several billion) blows up in his face. It would have blown up during 2008/2009 but Uncle Sam rode to the rescue, thus saving Warren’s bacon.

    2. JamesW

      Perfect points, Mr. Chase.

      Collateral transformation sounds like the Yankee version of rehypothecation.

  3. Skeptical

    It seems so obvious but it cannot be said often enough:

    Whenever you see financial deregulation, or clever attempts to sidestep regulation, the net impact is a marked drop in transparency.

    Which is why those who claim to oppose deregulation because they want “free markets” are full of BS.

    1. JamesW

      Speaking of “free markets” — a portion of something a friend sent me the other day:

      A short look at their “free market”: the Abacus CDO, which hedge fund guy, John Paulson, made $3.4 billion (paid off due to TARP bailout funds via the taxpayer), consisted of Paulson and Goldman Sachs working together to design a doomed deal, the Abacus CDO, full of crappy sure-to-default mortgages, then Paulson and GS purchased CDSes (naked credit default swaps, or unregulated insurance fraud instruments) against the sure-to-default deal they created and knowingly peddled.

      At $1.4 million per CDS, the return was $100 million per — only the banksters could create such instruments to defraud the public and dramatically increase the national debt by robbing and destroying the national tax base and tax revenues!

      Another example of designed-to-fail, pure insider trading: Magnatar Capital, a Chicago hedge fund with a 96% default rate on all their deals (same CDO/CDS scam) with the defaults triggering the CDS payouts.

      These, and many other similar deals, had nothing to do with progress, innovation, productivity or creation, they simply enriched a select few (pathological lying super-crooks and psychopaths) while destroying much — dramatically increasing the national debt — these examples are how all those multi-billionaires came into being, and why the debt is so colossal today.

      All those CDSes, much of it sold through AIG, is exactly why a $17 trillion bailout took place to pay them off ($16.1 trillion through the Federal Reserve during 2007-2009, with another $.9 trillion from Treasury).
      And nobody went to jail and the same super-crook, Gary Gensler, who enabled recent multi-billion dollar thievery of Jon Corzine at MF Global, is still head of the Commodity Futures Trading Commission (CFTC). (Corzine illegally stole segregated, or individual investment, accounts to pay off JPMorgan Chase’s margin call for their collateral.)

      1. Tom

        select few (pathological lying super-crooks and psychopaths)

        I would not give these criminals such a defense in the court of law.
        Even using the word crime, these people are mere extensions of the underlying corporate structure that is aligned to pushing the law beyond the bounds of original intent. They are run to make as much money with as little work or skin in the game. In fact, I believe, they work quite differently than a whirlwind-product-and-consumption business that, hopes to convert raw materials into a product and increase the size of their vortex while recycling money, products, labor and wealth into the real economy.
        These predator-and-predator-like companies are designed within the confines of existing law. Some folks did cross the line of clear law through William Black’s tried-and-true control fraud mechanisms and Gresham’s Dynamics. These folks certainly did it with intent and are the pinnacle of destruction. The companies are designed to convert estimated future values of any tangible good into current liquid negotiable instruments.
        When applied to a normal company, the predator owns its host and tells it to pay the leech the future value of the companies earnings in some liquid negotiable form. When the companies are told to downsize by the predator, when they are told to increase productivity – the predators are in fact weakening the prey while – on the books they show an increase in the companies earning potential from which the predator satiates itself. If done properly it can be beneficial but, if the predator (who is the major shareholder) decides to cash out the future value into his own pocket – the host don’t stand a chance – still the predator sells the company to anyone based on a distorted earnings profile. They sell to anyone who does not perform a veterinary check-up for rabies or kidney failure (virtually everyone).
        These people that run the predator companies are just plain lazy, cowardly morons who could not run a proper business in the real economy. Morons because, they keep supporting their ideas despite the evidence around them. Lazy because, they don’t want to work for real wealth creation – just money creation. Cowardly because, they have no interest in nations, war, hunger, fellow man the planet except to capture those future values – ahh yes – they do recognize that future values are going down because, they captured the future value in the form of money today – when it is high. Problem is they have invented a synthetic non-economy divorced from anything tangible to which they store this stolen cash – cash rarely to be seen circulating in the real economy again. The money is used to find more money from the future
        Of course they win in a normal market because they are storing money in the un-real market. This unreal market of theirs is being guarded from exposure to the risks that a normal markets have. – I can think of no other misallocation of money than, one that takes from a real consumption and production economy and circulates it into a non-consumption and non-production fantasy market.
        This was done under the current laws. even then the lazy moronic cowards couldn’t resist stepping over the line. They have become the completely government supported, crack smoking, selfish, lazy ass morons who are too stupid and infantile to give up their tit. Talk about nanny state – these idiots are the ones sucking on their government supplied crack pipe.
        Lazy ass, corrupt, criminal, cowardly crack smoking middlemen who defecate in public on both parties to the transactions they put themselves between. They see our laws and constitution as sheets of toilet paper that they pretend to civilly clean themselves up with. – Who let these asinine, turnip brained defecators out into the public square. We need leash laws for these idiots – tax em off the streets. Lock the criminals up. Repeal the laws that allow this to happen, make laws and taxes that keep their dung from posing a health threat to the rest of the world.

        Damn – that felt good.

        Hope I didn’t look too much like an idiot.

          1. Carla

            Gotcha. All of you’s above. So if we’re so smart, why aren’t we changing the system?

            Almost everyone I know has been cowed into voting for Obama. Only a couple of us (here in my little swing state Ohio life) are holdouts who will actually vote Green.

  4. Wayne Martin

    > to backstop the $648 trillion derivatives market.

    Given that the world yearly GDP is barely $50T, it astounds me that the Derivatives market could be this large, and wonder how it could ever be “collateralized” by the market itself, or the world’s “taxpayers”. Presumably the vast majority of these Derivative obligations are “naked”—and just nothing more than “bets” between people/companies with a lot of money.

    If “naked” Derivatives were outlawed, then this market would doubtless be tamed, rather quickly. It’s a real shame that we don’t have regulators, or congressional representatives, that are up to the job of mucking out this stable.

    1. JamesW

      And if President Obama were an authentic democrat in the FDR or JFK tradition, he wouldn’t have reappointed Neal Wolin, responsible for writing a giant amount of that Gramm-Leach-Bliley Act.

  5. Tom

    Taxes – not regulation – has always been the most powerful way to curb economically and …… etc. destructive practices such as gambling/speculation. Please do not confuse speculation with investments in the real production and consumption economy (like R&D and new company venture capital). Playing naked on the derivatives end should be taxed at whatever high level.

    Again I post and apologize in advance the following

    In spite of the ingenious methods devised by statesmen and financiers to get more revenue from large fortunes, and regardless of whether the maximum sur tax remains at 25% or is raised or lowered, it is still true that it would be better to stop the speculative incomes at the source, rather than attempt to recover them after they have passed into the hands of profiteers.
    If a man earns his income by producing wealth (money is not wealth – tom), nothing should be done to hamper him. For has he not given employment to labor, and has he not produced goods for our consumption? To cripple or burden such a man means that he is necessarily forced to employ fewer men, and to make less goods, which tends to decrease wages, unemployment, and increased cost of living.
    If, however, a man’s income is not made in producing wealth and employing labor, but is due to speculation, the case is altogether different. The speculator as a speculator, whether his holdings be mineral lands, forests, power sites, agricultural lands, or city lots, employs no labor and produces no wealth. He adds nothing to the riches of the country, but merely takes toll from those who do employ labor and produce wealth.
    If part of the speculator’s income – no matter how large a part – be taken in taxation, it will not decrease employment or lessen the production of wealth. Whereas, if the producer’s income be taxed it will tend to limit employment and stop the production of wealth.
    Our lawmakers will do well, therefore, to pay less attention to the rate on incomes, and more to the source from whence they are drawn.

    Written around 1925

  6. Andrew Foland

    “How Botched Derivatives Risk Taming Regulations are Again Going to Leave Taxpayers Holding the Bag”

    You say this like it’s a bad thing!

    Jonathan Kozol, in one of his books on American public education, once wrote something along the lines of, “When you see an institution continuously failing in its mission, year after year, through many organizational changes, then you probably have not properly understood its real mission.”

    I suggest that we might have misunderstood the mission of these regulations as fixing a botched system of derivatives, and should focus more on the second half of that sentence…

  7. Hugh

    If memory serves, I think some of the most toxic derivatives were going to remain outside the clearing houses. This article treats how the parties are going to game the system so that derivatives that are traded through clearing houses will remain undercollateralized. And then there are the heavily undercapitalized clearing houses themselves which are supposed to be the guarantors of the derivatives traded through them. It is all smoke and mirrors, Potemkin reform, but that was always the essence of Dodd-Frank.

  8. impermanence

    The idea that you should be able insure risk is fallacious in and of itself. Risk is risk. Don’t want to take it, fine, but if you do, don’t expect to be bailed out. This defeats the entire purpose of a measured return.

    These are the same people, when it comes time to face their mortality, will finally get it.

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