A Useful Primer on Derivatives Regulation

Bob Litan of the Brookings Institution recently penned an excellent overview of the issues surrounding derivatives regulation, with a particular focus on credit default swaps (CDS). ”The Derivative Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, and Other Interested Parties,” is really two pieces in one: a primer on derivatives policy and a warning about the power that a few firms now exercise over CDS markets.

Bob’s recommendations for reform (which I have numbered for convenience) are:

1. Induce or require “standardized” derivatives to be “cleared” on central clearinghouses rather than handled by dealers, acting on behalf of each of the parties (the buyer and seller) to these contracts.

2. Establish the conditions that will induce derivatives that are centrally cleared to be traded on exchanges or an equivalent transparent platform, as is now the case generally with stocks and futures contracts.

3. Ensure that adequate reserves – in the form of capital or margin – are held against all trades that are not centrally cleared.

4. Require the margin or collateral backing derivatives positions to be held either in segregated accounts or by third parties (such as a central clearinghouse) so that these funds cannot be co-mingled with other assets of dealers.

5. For derivatives that are both centrally cleared and traded on exchanges, regulators should ensure that the transaction prices and volumes of derivatives transactions are posted promptly on the equivalent of a “ticker” (post-trade transparency), while also ensuring that the prices at which buyers are willing to trade (the “bids”) and sellers willing to sell (the “asks”) are made public so that all parties, not just the dealers, know the state of the market at any given time (pre-trade transparency). I believe that a price ticker, or something close to it, should be in place even without central clearing and/or exchange trading.

Of course, much of the heavy lifting will be deciding which derivatives are “standardized.”