The Rush for Transparency Exemptions in Derivatives
First it was small and commercial issuers looking for an exemption to the new rules for over-the-counter derivatives. Fair enough, they weren’t responsible for the systemic meltdown, and making them trade truly bespoke instruments on an exchange and ante up additional collateral might have the effect of increasing their costs to the point of foregoing prudent risk management. Unfortunately, now it seems everyone wants in on an exemption from the requirements of Dodd-Frank, which could threaten the transparency that investors need.
This is a point of great concern to CFA Institute members. In a number of surveys in the weeks and months after the financial crisis began, members said that they felt blindsided by the over-the-counter (OTC) derivatives markets. The pricing was opaque and the magnitude of instruments trading in these markets was not readily apparent, even to this group of experienced and educated investment professionals.
Nor have these concerns waned in the intervening two years. In our latest Financial Market Integrity Outlook Survey members stated on a global and country-by-country basis that the OTC derivatives markets remain one of the biggest threats to global financial stability.
To remedy the lack of transparency and to increase the level of certainty, members have expressed a strong preference for exchange trading and central clearing of these instruments. The goal being that exchange trading would provide the kind of price determination and transparency that were lacking before the meltdown. Central clearing would bolster this by ensuring that some responsible, knowledgeable, and experienced professionals were monitoring the magnitude of risk in these markets and taking steps to keep it under management. Even in cases where exchange trading was not feasible, members still expressed a strong preference for greater transparency, such as through an electronic reporting mechanism.
Will FX derivatives get a pass?
Calls for exemptions, therefore, put the new rules to make these instruments more transparent in peril. Most recently, calls for exemption have come from dealers and end users in the FX swap market. The reason given is that these markets carry little systemic risk potential given the short time periods and limited values at risk.
CFA Institute volunteers on the swaps subcommittee to the Capital Markets Policy Council expressed ambivalence about the need for increased oversight of the pure FX swap market for similar reasons. At the same time, however, the subcommittee expressed dismay at the difficulty regulators would have in deciding which contracts should warrant exemption and which should not. If an FX swap should be exempt, then what about a cross-currency swap or a complex hybrid instrument incorporating a plain vanilla FX swap? (Actually, subcommittee members were quite clear on this distinction, calling for no exemption for cross-currency swaps due to their more complex nature.)
The most recent entrants into the exemption field are dealers who believe rules requiring five quotes for valuation purposes would cause a decline in liquidity for the swaps markets. Requiring firms to obtain five quotes for each instrument may be a little overboard, particularly for truly bespoke instruments where obtaining quotes may be like pulling Excalibur from the stone. Indeed, it is logical to expect that the number of available quotes would likely be a function of the liquidity as opposed to the other way around.
Once regulators start down the exemption road, it becomes increasingly difficult to reject exemptions. What is needed is greater transparency and common sense oversight, not regulation that imposes unreasonable requirements upon dealers, end-users, and clearinghouses alike. That is a tall order in a market as complex as swaps. What we can’t have, though, are huge swaths of these markets operating outside the boundaries of transparency.