Congress Considers Regulation of OTC Derivatives

 

Congress is finally working on legislation to regulate the $592 Trillion market for over-the-counter-derivatives, according to a recent article in USA Today by Paul Wiseman and Pallavi Gogoi. Derivatives include futures contracts to take delivery of an underlying asset, such as oil, at an agreed price on a certain date. These contracts are used by dealers in the underlying assets to manage the risk of price variations. They are also used by speculators to place bets on the direction of the price. Speculators provide the liquidity needed to have a market in which some derivatives are bought and sold.

Other derivatives do not trade on open markets. They are private deals that are negotiated “over-the-counter,” called OTC derivatives. “OTC derivatives are at the heart of the crisis,” the article quotes Christopher Whalen, managing director of Institutional Risk Analytics, as saying. The crisis is the derivatives-catalyzed collapse of subprime mortgages that led to the credit crunch and worldwide financial panic.

A derivative that is closely tied to the crisis is the credit default swap. A credit default swap is essentially an unregulated insurance contract in which one party agrees, for a “premium,” to insure payment of bond interest in the event of a default by the bond issuer. This is the type of contract that brought down AIG, which “insured” bonds issued by collateralized debt obligations that were in turn backed by subprime mortgage loans. At the end of 2008, there was $41.9 trillion of credit default swaps outstanding according to the article. That is a relatively small slice of the total derivatives pie as of the end of 2008, which also consisted of $418.7 trillion of interest-rate contracts, $49.8 trillion of foreign-exchange contracts, and $81.6 trillion contracts described as “other” (including equity-linked contracts and commodities), according to the article.

Part of the problem is the opacity of the OTC derivatives market, which Congress declined to regulate in 2000. Proposals to fix this vary, but most envision a public exchange in which these transactions can be monitored. University of California law professor Lynn Stout, who warned of a looming disaster back in 1995, recommends a return to the pre-2000 law in which derivatives contracts could not be enforced unless one party held title (or was obligated to hold title in the future) to the underlying asset ? analogous to the “insurable interest” requirement for insurance contracts. This would presumably prevent unwise speculation in derivatives contracts. But Stout doesn’t like what she sees from Washington so far. The article quotes her as saying: “We’re stepping backwards. We’re at grave risk of wasting this crisis, which means repeating it.” Whalen agreed: “If Congress doesn’t have the courage” to pass effective reforms, “we’re going to go through this all again.” It will be interesting to see whether Congress passes legislation that provides meaningful protection for the public or whether special interest groups head off such legislation.