By HAL S. SCOTT
Originally published by Wall Street Journal on July 15, 2013
Last week’s announcement of a “Path Forward” by the U.S. Commodity Futures Trading Commission and the European Commission is an important step toward coordinating the rules for derivatives trading. However, the agreement’s failure to address conflicts in rules for clearinghouses—which will handle the vast majority of the trades and the trillions of dollars of collateral posted by the world’s largest banks—is a troubling omission. There is still much work to be done.
The $630 trillion market for derivatives is a testament to their importance for corporations in the United States and elsewhere that seek to hedge financial risk. The two most important types of derivatives are interest-rate swaps and foreign-exchange swaps, which together account for about 90% of outstanding derivatives globally. Interest-rate swaps allow corporations to manage the risk that their borrowing costs will rise in the future. Foreign-exchange swaps allow corporations with revenues or expenses in a foreign currency to hedge the risk that the value of that currency will rise or fall.
Another derivative, the credit-default swap, allows corporations to hedge against the potential default of another corporation—for example, a major funding source or supplier. However, credit-default swaps (which amount to $25 trillion globally) are regulated by the Securities and Exchange Commission and are outside the new agreement.
The financial crisis demonstrated that trading in derivatives can bring down a multitrillion dollar corporation like the insurance giant AIG and potentially threaten the entire financial system. The U.S. government said the bailout of AIG was necessary because the corporation lacked sufficient collateral to pay its credit-default swap counterparties, which included Goldman Sachs and Deutsche Bank.
To protect the financial system, the European Union and the U.S. have required that the vast majority of swaps pass through clearinghouses, whose members will collectively absorb the loss of the default of any counterparty to a trade. Since financial risk has been concentrated in these clearinghouses, the rules that govern their safety are crucial to the stability of the financial system.
Clearinghouses exist on both sides of the Atlantic, but conflicting rules might interfere with their ability to clear trades between a U.S. bank and an EU bank. This is not a minor issue: More than 80% of credit-default swaps are made across borders, and twice as many interest-rate swaps are executed in the United Kingdom as in the U.S. Differences between the EU and U.S. rules are directly related to the ability of derivative clearinghouses to withstand a financial crisis.
The Committee on Capital Markets Regulation, a private, independent nonprofit, has identified nearly 20 such conflicting rules. U.S. regulators, for example, require a U.S. bank to post more than twice as much collateral for a cleared interest-rate swap as do the EU rules for a European bank. Considering that there is about $500 trillion in outstanding interest-rate swaps, the vast majority of which will be cleared, this difference in rules about collateral is notable. The rule difference was acknowledged but not addressed in the Path Forward agreement.
There are other rule differences and issues that need to be addressed. The European Union’s clearinghouses must hold sufficient financial resources to withstand the failure of its two largest members. The Commodity Futures Trading Commission only requires U.S. clearinghouses to be able to withstand the failure of its largest member.
U.S. clearinghouses have access to the Federal Reserve during a liquidity crisis. EU rules do not provide for clearinghouse access to the European Central Bank.
Finally, if the resources of a clearinghouse are depleted in a financial crisis, there are no rules in either the U.S. or EU for how a clearinghouse can assign losses to the large banks that make up its membership. Harmonized rules of the road need to be negotiated to allow for the orderly allocation of losses during a crisis. And the SEC, which regulates credit-default swaps, should be brought into these negotiations.
For the time being, a new exemption adopted by the Commodity Futures Trading Commission enables U.S. companies to clear their trades under the rules of EU clearinghouses and vice versa. But their ability to do so will expire at the end of 2013.
Mr. Scott is professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation.
Reprinted from The Wall Street Journal, copyright 2013 Dow Jones & Company. All rights reserved. A version of this article appeared July 16, 2013, on page A13 in the U.S. edition with the headline: Land Mines in the Derivatives ‘Path Forward’.