To European officials, financial derivatives are dangerous weapons that worsened Greece’s debt crisis and should be curbed.
To Wall Street, they’re tools that reduce risk and generate profits and should be left alone.
Now, regulators on both sides of the Atlantic are trying to figure out who’s right and what to do about it. At stake are billions in profits that banks say would be threatened by too much regulation. Yet supporters of tougher rules say the global financial system is at risk as long as derivatives remain largely unregulated.
Derivatives are instruments whose value depends on an underlying asset, such as mortgages or stocks. They can help hedge risks. But derivatives can also produce steep losses, or huge profits, if the value of their underlying asset sinks.
European officials say some derivatives are too harmful to be left alone. They warn they may ban some credit default swaps, a type of derivative that insures debt. In a visit to Washington this week, Greece’s prime minister argued that speculators were using the swaps to bet against his country’s debt. He said this has escalated Greece’s borrowing costs, making it harder to dig out of its debt crisis.
The European Commission on Tuesday threatened to ban speculative trading of credit default swaps by investors who don’t actually own a country’s underlying debt. These are called “naked” trades. German Chancellor Angela Merkel called on the US to curb such trades.
But US regulators have resisted such calls. They favor only regulating the products, not curtailing them.
Coordination of any derivatives regulation is vital. Unless rules in the United States and Europe are synchronized, global traders inevitably would shift to wherever the most lenient rules exist.
The regulatory conflict comes days before the expected unveiling of a bill to overhaul the US financial system. Sen. Christopher Dodd, D-Conn., the Banking Committee chairman overseeing the legislation, wants more transparency in derivatives markets.
His bill is expected to require most derivatives trades to pass through clearing houses so transactions would be done more openly. Such transactions are now largely traded among financial institutions with little transparency or regulatory oversight. Critics say this can lead to abusive and dangerous behavior.
Speaking in New York this week, Gary Gensler, head of the US Commodity Futures Trading Commission, renewed his call for regulating the $600 trillion global financial derivatives market. But he stopped short of endorsing Europe’s call for trading curbs.
Whatever rules Congress proposes, Gensler said “there should be no such exemption for” credit default swaps. The swaps account for an estimated $60 trillion of the derivatives trade.
The banking industry says it supports making derivatives less secretive but has lobbied against strict bans.
In a September speech in Germany, CEO Lloyd Blankfein of Goldman Sachs, one of Wall Street’s biggest derivatives players, embraced the idea of clearing houses. He said they would “reduce bilateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades.”
But he warned against overregulating credit default swaps. He said the swaps “worked as they were intended to” during the financial crisis.
“If we simply ban customized derivatives to satisfy the perception that everything associated with these markets is bad, we run the risk of limiting … business investment and, ultimately, economic growth,” Blankfein said.
The main lobbying group for derivatives has also rejected calls for banning certain credit default swaps. It says the amount invested in the swaps cannot destabilize Greece because it represents only a small fraction of the country’s outstanding debt.
Investors hold $406 billion worth of outstanding Greek bonds, according to Citigroup. But they hold only $9 billion in insurance against that debt through credit default swaps.
Given the relatively small amount of swap bets, “it is difficult to conclude (they’re) dictating price levels,” the International Swaps & Derivatives Association said in a statement.
After the 2008 collapse of Lehman Brothers, then the largest clearing house for swaps, EU regulators demanded banks set up clearing houses for trades in Europe. So far, three EU-based clearing houses are operational: ICE Clear, Eurex Clearing and LCH. Clearnet SA.
Speaking this week, Gensler said US authorities are “working well” with overseas regulators.
“I’m optimistic we’ll end up at roughly the same spot,” he said.
Yet already there are signs that not even regulators within Europe agree on how dangerous derivatives really are. Germany’s Merkel is calling for a ban on speculative credit default swaps. Yet her country’s market regulator, BaFin, said this week it’s found no evidence of an upswing in such trades on Greek government bonds.
A major cause of the rise in credit default swap rates has been growing demand for hedging against Greek risk, according to BaFin. It said data released by the US Depository Trust & Clearing Corp. “do not point to massive speculative activities.”
The Federal Reserve is investigating how Goldman Sachs and other banks are using the swaps and other derivatives. The Securities and Exchange Commission is examining the issue, too.
The securities industry says that blaming the products for Greece’s problems is akin to shooting the messenger. The price of the swaps reflects merely the perceived risk of buying Greece’s debt, it says.
A year ago, credit-default swap investors had to pay $250,000 to insure $10 million of Greek debt, according to CMA Datavision. By last month, the cost surged to a record $420,000.
As of Wednesday, the rate had fallen to less than $300,000 after Greece announced a $6.5 billion austerity package. Still, that’s about 10 times the cost of insuring $10 million of U.S. debt.
Some financial experts have criticized Greece for attacking credit default swaps instead of owning up to its profligate spending and efforts to mask its debt. In a recent report, Citigroup likened Greece’s stance to “blaming the mirror for your ugly face.”
“Credit default swaps didn’t cause Greece’s problems,” said Darrell Duffie, a finance professor at Stanford University. “Greece caused Greece’s problems.”