Wednesday, July 27, 2011

Soothing Words from a Bygone Era

Brooksley Born whom I mentioned earlier had a predecessor at the Community Futures Trading Commission. She was Reagan appointee Wendy Gramm, wife of Phil Gramm. She was later involved in the Enron scandal using her position at the CFTC to make sure Enron wasn't regulated then leaving the CFTC to become a board member at Enron.

"Soothing Words about Derivatives; Futures Regulator Says Risks Have Been Exaggerated"  (American Banker, September 21, 1992)
Futures Regulator Says Risks Have Been Exaggerated

Wendy L. Gramm, chairman of the Community Futures Trading Commission, had some advice for the nervous Nellies of the regulatory world in a speech to the futures industry here last week. She had several words for regulators who would meddle with the derivatives markets. What follows are some excerpts of that address:

Lately, I've been hearing various regulators raise concerns about off-exchange markets and about derivatives generally. The questions they're raising include:

* Are derivative markets too big, too risky, placing the clearing system in jeopardy?

* Are derivatives and their risks simply too esoteric and complex for anyone but a rocket scientist to understand?

* Are the derivative markets underregulated?

First, there is notion that the size of the derivative markets could disrupt the financial system: When people talk about swaps, we often hear figures in trillions of dollars.

But it's important to remember that such dollar amounts refer to the notional principal, which is much greater than the value of the contact -- which in turn is much greater than the actual cash flows per day.

Indeed, cash flows due to swaps are tiny compared with the daily cash flows from trading in foreign exchange -- over half a trillion dollars a day.

It Isn't Brain Surgery 

Second, as to the concern that derivatives are too esoteric, and the perception that derivatives are overcomplicated and too difficult to price: Well, you and I know that the pricing of many derivatives is simple and well understood, indeed, simpler than some cash market instruments.

Moreover, some are making the point that as banks begin to value loan portfolios the way they value derivatives, they're doing a better job of assessing risks.

Finally, the idea that derivatives are unregulated or insufficiently regulated: I frequently have to remind people that the CFTC does regulate exchange-traded commodity futures and options, while the SEC regulates options on equities.

While off-exchange derivatives may not be directly regulated by a governmental agency, the entity offering these instruments or acting as an intermediary for the products is often regulated.

Safeguards Have Evolved

Besides, markets used by sophisticated, informed institutions tend to develop their own system of safeguards and protections.

What about the regulations? What should those issues be -- what really needs to be done from a regulator's perspective?

First, allow innovation. Don't pull up everything green just because it might be a weed. It could grow into a flower.

The challenge for financial regulators is to carry out our mission of ensuring fair and efficient markets without stifling innovation.

Derivatives markets are based on notional principal amounts that are much greater than daily actual cash flows. Cash flows from swaps are much less than flows from foreign exchange trading. Derivatives pricing is simpler than various cash market instruments. Banks are also assessing derivatives risks as they value loan portfolios. In addition, securities firms which offer derivatives are tightly regulated by government agencies.


Soothing words about derivatives; futures regulator says risks have been exaggerated Source: American Banker. 157.182 (Sept. 21, 1992): p6.