The Dewatering Hole

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.” The actual language of the 115-page proposal follows quite closely what Geithner has been floating for several months—a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on. A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.

There is an aggressive timeline for most of these rules: 180 days. Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together. Many of the provisions require that the CFTC and SEC issue rules jointly with the proviso that, if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze. But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrong-headed, and ignores crucial economic issues. The proposal does not require clearing when “one of the counterparties to the swap— (1) is not a swap dealer or major swap participant and (2) does not meet the eligibility requirements of any derivatives-clearing organization that clears the swap.” This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature and would permit end-users to enter swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market. However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuses and creates ambiguity in the application of this exemption from the clearing requirement.

It is a travesty to call this the “Improvements to Regulation” act. All of the substantive element—the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits—have no solid economic justification.

Indeed, the stronger justifications cut the other way in virtually every case. Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on. The delegation of virtually all implementation details to regulators, the rapid timeframe for the formulation of specific rules, the need for coordination across regulators and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (Further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

–Craig Pirrong

About the author: A recognized energy-markets expert, Craig Pirrong is director of the University of Houston’s Global Energy Management Institute and a professor of the university’s carbon-trading course—the first of its kind in the U.S. The institute is part of the university’s C.T. Bauer College of Business. Pirrong joined the university in 2003. He previously was the Watson Family professor of commodity and financial-risk management and an associate professor of finance at Oklahoma State University, and was on the faculty of the University of Michigan Business School, the graduate school of business of the University of Chicago and the Olin School of Business of Washington University in St. Louis. He holds a Ph.D. in business economics from the University of Chicago. The full version of Pirrong’s commentary on OTC derivatives—including details on the peculiarities as to what constitutes a swap dealer or major swap participant that confuses and creates ambiguity in the application of this exemption from the clearing requirement—and on more energy subjects is available at his blog www.streetwiseprofessor.com. He can be reached at cpirrong@gmail.com.

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