HOW TO STOP ANOTHER DERIVATIVES INFERNO / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

How to stop another derivatives inferno

By Gary Gensler

Published: February 24 2010 20:17

On October 8 1871, what started as a small fire swept across Chicago to destroy much of the city. The story goes that it was ignited when Mrs O’Leary’s cow kicked over a lantern in her barn. Many buildings were made of wood, so the fire spread quickly. In the years after the fire, Chicago implemented new building and fire codes. Those rules now protect the residents of Chicago from the spread of future fires.

In the autumn of 2008, certain financial institutions kicked over the lantern that set off the financial crisis – a fire that nearly burned down the global economy. In America, more than a year later, unemployment is at nearly 10 per cent. Most of those who have lost their jobs never used the flammable financial contracts that helped create the crisis. As regulators, we have a responsibility to establish codes that will ensure the concentrated, opaque derivatives market never again brings the financial system to the brink of collapse.

Derivatives are meant to help lower risk and make it easier to discover the price of risks and assets. But unregulated derivatives heightened and concentrated risk and lessened transparency, making it harder to price risks and assets. US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system. As we later learnt, much of the bail-out money flowed through AIG to US and European banks. The recent chill winds affecting the euro have further revealed how derivatives can be used by a sovereign country, such as Greece, to borrow from a financial institution, while obscuring the embedded loan.

Now we must rebuild the global economy, working across international borders, in a way that protects the public and market participants. Effective reform of the over-the-counter derivatives market requires three essential components that exist in the regulated securities and futures markets.

First, we must explicitly regulate the financial groups that deal in derivatives. They should be required to have sufficient capital and to post collateral on transactions so that the public does not bear the costs if they fail. Dealers should be required to meet robust standards to protect market integrity and lower risk, and should be subject to stringent record-keeping requirements.

Second, to bring transparency to market participants and the public, standard OTC derivatives should be required to be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties of a derivatives transaction. During the financial crisis, Wall Street and the US government had no price reference for particular assets – assets that we began to call “toxic”. Financial reform will be incomplete if we do not achieve public transparency that will lower risk in the derivatives market.

Third, to lower risk further, standard OTC derivatives should be brought to clearing houses. Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Many of the financial institutions that kicked over the lantern in 2008 now oppose critical aspects of reform. This should be expected; after all, regulatory reform would mean big changes for the biggest banks. But Wall Street’s interests are not always the same as the public’s. Banks have a duty to their shareholders to maximise profits. In 2008, we watched them fail to manage their risks. It is now time to enact reform so that taxpayers no longer bear the price of Wall Street’s mistakes.

Chicago rebuilt itself with new rules to limit the risk of fire. We, too, should establish rules to protect the public from OTC derivatives. If we do nothing, we risk another financial fire that will cost even more jobs.

The writer is chairman of the Commodity Futures Trading Commission

Copyright The Financial Times Limited 2010