Tags: financial | swap | derivatives | market

Full-Court Press on the Financial Industry Is Required

By    |   Friday, 12 September 2014 08:19 AM EDT

Following the economic catastrophe six years ago, the implementation of serious and rapid reforms were essential for the financial industry. But U.S. regulators are becoming impatient with the lack of progress to date.

It is incumbent on U.S. federal regulators to begin a comprehensive full-court press on the financial industry to ensure it acts more responsibly, lest the United States and the world experience another financial cataclysm in the near future.

Derivative exposure remains a threat to the U.S. and global economy.

At the end of 2013, the global swap market had a face value of approximately $540 trillion, 76 percent of the $710 trillion global derivative market. Swaps are derivative contracts in which one counterparty exchanges its cash flow from a financial instrument with that of a different instrument from another counterparty. This is done to hedge investment risks in physical commodities and financial instruments.

Ideally, these swap trades require a capital reserve cushion to offset possible losses, much like an insurance company maintains reserves in the case of unforeseen events. However, U.S. financial institutions that have hundreds of trillions of dollars in swap derivative exposure are averting this practice and transferring the risk to its foreign subsidiaries.

This risk transfer is identical to what precipitated the financial catastrophe of 2007 and 2008. Unchecked, this risk will metastasize throughout the world, resulting in a high degree of uncertainty. As uncertainty rises, the flow of funds declines, generating higher unemployment and lower incomes for some time.

Additionally, the traders have not instituted a transparent electronic trading platform with centralized, real-time pricing for all investors. Unfortunately, for decades, these trades have been cleared in opaque, unregulated and risky over-the-counter venues.

The primary regulator of the swap market is the Commodity Futures Trading Commission, which is seriously exploring how capital reserves can be increased with the help from other regulators, such as the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, the Federal Reserve and the Securities and Exchange Commission (SEC).

The Federal Reserve is also proposing a capital reserve surcharge for banks that rely heavily on overnight borrowing to avert the severe liquidity shortfall, a major cause of the financial meltdown.

The SEC is now exploring whether the $50 trillion asset management industry needs additional regulation to avert a market catastrophe. Stress tests are being considered to guarantee that the funds these firms manage possess enough liquid assets to finance massive redemptions during severe market volatility.

Making matters worse, these asset management firms have been ramping up their sales of alternative mutual funds, which contain derivative products on the balance sheet. Laurence Fink, CEO of BlackRock, which has nearly $4.6 trillion under management, recently said these derivative vehicles "have a structural problem that could blow up the whole industry," The Wall Street Journal reported.

The SEC is also examining whether the market exchanges provide the proper market pricing integrity to all investors. Currently, the exchanges are subject to self-regulation.

This may have worked better when they were nonprofit entities with a more objective market making capability. However, in recent years, many exchanges became public, for-profit structures. Recent class action lawsuits allege some exchanges provided unfair competitive advantage and access to high-frequency traders for a fee, and claim this led to market manipulation that undermined market integrity.

These efforts need to addressed quickly and comprehensively to avert another economic crisis.

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Following the economic catastrophe six years ago, the implementation of serious and rapid reforms were essential for the financial industry. But U.S. regulators are becoming impatient with the lack of progress to date.
financial, swap, derivatives, market
Friday, 12 September 2014 08:19 AM
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