Gary Gensler, the former Goldman Sachs Group Inc. partner now heading the Commodity Futures Trading Commission, has never been a dawdler. So it was unnerving to see the CFTC miss a major deadline for its biggest project: redefining derivatives markets to prevent a repeat of 2008-style mayhem.
The CFTC says it now needs until year-end to finish regulations that had been due in mid-July. Outside experts, such as Stanford University finance professor Darrell Duffie, think longer delays are likely. Meanwhile, Republican opposition is mounting, as seen by Kentucky Senator Mitch McConnell’s recent declaration that “anything we can do to slow down, deter or impede” the regulators’ agenda would be “good for our country.”
The senator is wrong: The CFTC’s rule-making efforts are needed to tame the largely unregulated market for over-the-counter derivatives, where $300 trillion of contracts trade in the U.S. alone. Such markets remain highly opaque; information about transaction prices, trading volume and collateral is scanty or outdated. Although it’s not unreasonable to ask for six more months, the CFTC should enact its core ideas by the end of this year. Fine-tuning can come later.
It’s important to remember that the upheaval of 2008, involving credit-default swaps tied to the U.S. housing market, could happen again. Back then, after the bankruptcy of Lehman Brothers Holdings Inc., American International Group Inc. couldn’t make good on its swaps obligations. Only a $182 billion federal infusion kept AIG’s woes from wrecking other firms, and the global economy.
Ambitious Road Map
The CFTC’s road map so far is ambitious and intricate, involving 51 proposals. In some cases, the agency is trying to write such a detailed script for how markets should work that it isn’t leaving enough room for participants to sort out what structures will work best. As potential market participants (including Bloomberg LP, the parent company of Bloomberg News) have pointed out in comment letters, allowing more flexibility could help get to the finish line faster.
To improve trade execution, for example, the CFTC is trying too hard to model new derivatives exchanges -- they go by the balky term “swap execution facilities” -- on existing stock and futures exchanges. Swaps aren’t like stocks, or even exchange-listed futures. Many are custom-made for one company; some are contracts that last decades and rarely change hands. More important, there are few if any retail investors to protect in the swaps markets.
The Securities and Exchange Commission, which shares authority with the CFTC over swaps regulation and has vast institutional knowledge about what makes a successful exchange, has adopted a more flexible approach for the instruments under its jurisdiction. The SEC’s rules would allow creative new market structures to emerge, instead of a one-size-fits-all regime.
To improve price transparency, a worthy model already exists: the TRACE reporting system for corporate bonds. Set up in 2002, the Trade Reporting and Compliance Engine provides details of corporate bond deals within 15 minutes. Posting bond prices on the website of the Financial Industry Regulatory Authority effectively restrains bond dealers from charging excessive markups to customers. A 2006 academic study concluded that trading costs declined by about 50 percent, saving $1 billion a year.
A similar system could provide swaps prices within minutes of a deal’s completion. This would help lower costs for corporate customers, which use derivatives to offset the risk that interest rates, commodity prices or exchange rates might move against them.
The CFTC is also caught up in a protracted tussle about registration rules for U.S. banks’ foreign branches. The Dodd-Frank financial reform law doesn’t provide a clear roadmap for who should oversee, say, a derivatives transaction written in London between the British arm of Citigroup and an Irish unit of Google. To prevent derivatives business from gravitating to countries with the laxest rules, the thinking went, some CFTC rules might need extraterritorial reach.
Yet closer coordination with non-U.S. regulators may be a more practical way of making sure standards stay high worldwide. That would avoid legal headaches that arise when the U.S. tries to impose its rules on other countries.
Market regulation is always a work in progress. Long delays at the CFTC wouldn’t just leave market participants in limbo; too slow a pace also opens the door for politicians to hobble the commission itself. Worse, allowing the perfect to be the enemy of the good risks another AIG-style crisis.
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