Five years after the financial crisis, one might think that the derivatives world hasn't really reformed. However, steady progress was already taking place years before the Dodd-Frank Act seeking to reform Wall Street was enacted.
A Lack of Official Progress
A popular notion is that policymakers may have wasted the financial crisis of 2008 by failing to quickly enact large scale regulation of over-the-counter derivatives and other areas of finance. Supporting this idea is the undeniable fact that derivatives regulators have yet to enact many of the regulations required by the Dodd-Frank Act of 2010.
As the long bar in the middle of the following chart from Davis Polk's September 2013 Dodd-Frank Status Report shows, regulators are way behind, having missed half of their deadlines.
The Financial Stability Board (FSB) also has a graphic illustrating the pace of derivatives reform globally. The lack of green in the following graph from the FSB's September 2013 status report on global market reforms shows that the reforms are overwhelming incomplete.
An in-depth investigation by Bloomberg reporters Silla Brush and Robert Schmidt provides at least a partial explanation. The authors detail the massive amounts of time and money spent by financial sector lobbyists to shape derivatives regulation, including how it applies to commercial firms, overseas trades, and the number of counterparties a regulated swaps trade must be made available to before a deal may be closed.
Market Evolution
But despite the lack of official progress and the millions spent by finance lobbyists, the simple fact is that the derivatives market has massively improved since the financial crisis.
For starters, the types of deals that triggered the bailout of American International Group, Inc. are no longer done. Synthetic mortgage-related securities that used credit derivatives to spread and magnify the risk from subprime mortgages are nonexistant. Investors, and even banks, seemed to have wised up (and the trades would no longer be profitable, in any case).
The plumbing underlying the derivatives market has moved out ahead of regulation as well. Through 2006 and 2007, dealers of credit and equity derivatives reduced a potentially dangerous backlog of outstanding trade confirmations and moved towards using electronic systems.
During and in the immediate aftermath of the financial crisis, the improvements continued. By year-end 2008, "netting" (or tear-ups) of redundant risk exposures reduced commercial banks' over-the-counter derivatives exposures by 88% (or just over $6 trillion). The use of collateral in derivatives transactions had been on an upswing as well, with 65% of trades subject to collateral agreements by year-end 2008--almost double the proportion in 2003. 2009 was also an important year: the Depository Trust Clearing Corporation began to obtain enough information to allow regulators to have a complete picture of all credit default swap trades, and the industry adopted the Big Bang contract standardization protocol which brought more order to the market.
And despite the full force of Dodd-Frank derivatives rules failing to become a reality, numerous improvements were recently made or are in the works. These improvements include industry-wide revisions to definitions in the context of sovereign debt restructurings and elsewhere, electronic transaction identifiers, more accurate and widely-available pricing services, and improved accounting standards.
Why Regulation Was Not Necessary for the Improvements
The foregoing improvements to over-the-counter derivatives markets did not require final regulations in part because regulators pressured the industry to reform and the Dodd-Frank Act indicated what would eventually be mandated.
But a more fundamental reason stems from the unique economics of derivatives. The trades create long-term relationships and dealers--the primary players in the market--take both sides. As I've explained in a previous article, the fact that dealers are counterparties to both buyers and sellers means that they do not act like typical "sell side" banks. Instead, they have an incentive for the market as a whole--both sell side and buy side--to function smoothly. Accordingly, dealers have an incentive to adopt reforms and get behind their widespread adoption.
There is no doubt that derivatives markets still have a lot of progress to make. Nonetheless, it would be a mistake to overlook real improvements simply because of the slow progress of new regulations being enacted.
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