Streetwise Professor Criticizes Regulators for Failure to Grasp OTC Markets
Commentary by Bob Zwirb
University of Houston Finance Professor Craig Pirrong criticized regulators for prioritizing OTC derivatives market reform while ignoring the "myriad connections of this market to other parts of the financial market."
In a recent Streetwise Professor blog post, Professor Pirrong paid particular attention to the ways in which U.S. regulators used OTC market reform to address systemic risk, saying that regulators' understanding of how the OTC derivatives markets interacted with the entire financial system was "simplistic" and did "great violence to complex reality." He also suggested that the regulators who were tasked with the reform had a "profoundly unsystemic" understanding of the financial system as whole:
"[T]he regulators thought they could reform the system piece by piece, without thinking seriously about how these pieces interacted in non-linear ways."
Professor Pirrong noted that recent efforts to map the financial system more accurately were an improvement over similar efforts by previous regulators, but also expressed concern because data regarding incentives, the distribution of information and the motivations of market participants will not be captured even in recent mapping.
Commentary
The intent of a number of the reforms in Title VII of Dodd-Frank (in particular, central clearing) was to "transform . . . opaque bilateral counterparty credit relationships into a 'hub and spoke' arrangement." Ivan Ruffini and Robert Steigerwald, OTC Derivatives – A Primer on Market Infrastructure and Regulatory Policy, p. 90 (Nov. 25, 2014). Regulators generally prefer the latter because it is said to be simpler and more transparent. But "reality," as Fed. Governor Jerome H. Powell explains (and as Professor Pirrong affirms here) "is not so elegant." Governor Jerome H. Powell, "Central Clearing in an Interdependent World," speech delivered at the Clearing House Annual Conference, New York, New York (November 17, 2015). Even under the hub-and-spoke model, as Powell explains, things get more complicated with "multiple CCPs, even within product classes, and major dealers act[ing] as clearing members across a broad network of CCPs."
Likewise, central clearing "does not completely eliminate opacity or interdependence," as Ruffini and Steigerwald argue citing several reasons, including (i) the fact that CCPs become the substituted counterparties only to transactions between clearing members, and (ii) the lack of transparency for end users regarding a CCP's fellow-customer risk. Ruffini and Steigerwald, at 90-91.
Related Articles
-
University of Houston Finance Professor Craig Pirrong asserted that Deutsche Bank's exit from U.S. swaps clearing due to capital cost concerns is symptomatic of "how major portions of Dodd-Frank and the regulations emanating from it need a thorough review and in some cases a major overhaul."
-
University of Houston Finance Professor Craig Pirrong argued that regulatory efforts to make central counterparties more resilient might help to mitigate credit risk, but they also exacerbate liquidity risk, which in turn creates the "recipe for a broader market crisis."