Need for a balanced and practical approach - Regulating the OTC Derivatives market

As legislators prepare to move ahead in debating the recently introduced draft bill on regulating OTC derivatives, several observers have questioned the need for the bill to be diluted, both in terms of coverage and in terms of regulatory oversight mandated. With over USD 600 trillion in notional amount & the stigma attached to CDS instruments (thanks to AIG) due to the current financial crisis, it is easy for one to be led astray and push for a total clamp-down on the market. However, we need to ensure this is looked at from the right perspective.

Regulation is very much needed and so is enhanced reporting and disclosure - without going in to an argument on Value at Risk Vs notional amounts, the very fact that US financial firms make over USD 30-40 billion+ in annual profits from such instruments gives an idea of the level of implied risk in this segment of the financial market. However, it is to be noted that not all of the volume is driven by speculative positions. To put this in perspective, a majority (65%+) of the USD 600 trillion notional pertains to Interest Rate Swaps (IRS) and close to 10% pertains to Currency swaps; and only about USD 60 trillion pertains to the much-vilified CDS bucket. And this is not to say that CDS as an instrument has any inherent flaws - it is as much necessary to create a vibrant credit market as is oil futures and options for a vibrant crude oil market.

More over, close to USD 60 trillion of the USD 600 trillion notional pertains to positions by non-financial firms, where they are hedging real risk associated with variables like interest rates, foreign exchange rates and commodity prices to reduce profit volatility related to factors not linked to their core business. Also, a significant portion of the IRS market would be covered swaps with hedged counter-positions on the books of financial services firms (banks using a pay floating-receive fixed swap to hedge interest rate risk on their floating rate loan pools for example).

To put it in a nut shell, the OTC derivatives market plays a significant role in maintaining a well-oiled financial services world. Over-regulation without understanding the true nature of the market kills the industry and reduces liquidity from the financial services market as a whole. The very nature of customization associated with loan tenures, currency positions etc is what makes the market so difficult to be managed through a pure exchange-driven mechanism. This is the very reason for large delays between trade execution and settlement, and hence accumulation of settlement risk. A regulatory push towards enhanced disclosure and reporting, and hence supervisory review of systemic risk, is a good idea - but draconian rules related to reporting or margining will add disproportionate costs and hence eventually strangles the industry.

Having said this, the directive towards moving a larger portion of the OTC Derivatives volume to central clearing houses is laudable. This is as much a solution to industry woes as for regulators' woes - the positive industry response to DTCC's Trade Information Warehouse a few years back & success of other service providers like Markit and TriOptima clearly shows that there is proven business value attached to central parties which can facilitate information exchange and drive information accuracy. However, a few points need to be noted:

• Centralized clearing houses do create systematic risk due to aggregation of risk to a single counterparty. So, unless strict norms around capitalization of these clearing houses is part of the mandate, the move could be counter-productive in the longer term.
• What is more important than centralized information is how regulators and industry uses this information. Unless there is a good mechanism to roll up exposures across related parties and highlight areas of risk concentration, along with a clear mechanism of regualting the same by supervisory oversight, the central clearing house solution doesn't provide any real relief. For example, several large US firms had exposures to multiple Lehman entities (collateral pledged with Lehman US and Lehman UK separately for example) and since analysis of rolled-up exposures to Lehman group as a whole was not done or acted upon, realization of the overall exposure happenned only post-event.
• Margining requirements have to be as tight on non-financial firms as on financial services firms. I do not personally agree with the opinion that stricter margining requirements dilutes business value for firms using it as a true hedge. I agree that it does entail added costs to doing business, but if the regulation is lax towards non-financial firms in this area, it leaves a big loop hole. Nothing stops rogue financial arms of oil companies or any others from creating Enron-like situations due to unregulated open exposures in derivative positions.

To summarize, we do need fresh regulations on facilitating centralized counterparty driven clearing, enhanced reporting and stricter margin requirements; however, regulators need to work closely with industry leaders and industry SROs to ensure that we create an environment for controlled growth and not lead to total market constriction. On the same note, we have to be careful on diluting rules for select areas of the market - since loop holes almost always are exploited by smart players in the market!

Do we have a sustainable economic recovery yet?

Forecasts and projections galore over the past 3-4 months as the DJIA (read market indicators) gradually worked its way almost inching up to the 10,000 mark. Thankfully, unlike the all-pervading gloominess in early March, the biggest question currently in the minds of market pundits and investors is whether the rally is sustainable. Led from the front by Roubini, there are several economists forecasting a double dip recession and the market reverting back to pre-rally levels. Though I personally agree more with Summers than Roubini, it's difficult to stretch the optimism at this point to say that the market is completely on track to a V-shaped reversal.

A quick look a factors which support the sustained rally camp:

• Job losses are stabilizing - by labor department statistics, total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with lossses averaging 645,000 per month from November 2008 to April 2009.
• Manufacturing supplier and purchaser indexes are up - for example, the Institute of Supply Management PMI index has gradually increased from 40.1 in April 2009 to 52.6 in Sep 2009, showing an uptick in 4 out of 5 month-to-month instances.
• Home price decline has been stopped across all major regions, with month-on-month price ncreases reported for Sep 09. Also, both new and existing home inventory are down to the 7-8 month levels as compared to the 11+ months inventory in Q4 2008 and Q1 2009.

On the other hand, those forecasting a double dip recession point to lack of fundamental strength in key indicators:

• Corporate budgets are generally flat and employers have not started hiring. This is supported by continued increase in unemployment, reduction in hours worked and lack of strong private sector new employment generation
• Manufacturing stats are just showing a blip to shore up inventories back to minimum levels
• Home foreclosure rates have not slowed down and home prices have not yet shown a consistent upward trend

Let's take a look at some of the key numbers from April to Sep 09 (wherever data is available):

Apr May Jun Jul Aug Sep

Personal consumption expenditure (USD trillion) 9.18 9.19 9.20 9.22 9.31
Unemployment rate (%) 8.90 9.40 9.50 9.40 9.70 9.80
ISM index 40.10 42.80 44.80 48.90 52.90 52.60
Bank lending (USD btrillion) 9.25 9.34 9.33 9.26 9.20 9.11
New home sales (annualized in '000s) 352 346 384 429 426

(sorry for the mess up on the table - could not get it in neatly!)

As can be seen clearly, while new home sales and manufacturing indicators (using PMI as a proxy) has shown notable progress over the past 6 months, bank lending has yet to show any progress of improvement and so is the unemployment rate. This probably confirms the view that there is still quite some way to move forward for a sustainable recovery. Also, considering near-flat trends for personal consumption expenditure and hence fundamental demand drivers in general, it is perhaps easier to agree with the view that manufacturing stats are up primarily due to re-stocking pressure - due to drastic production cuts and abnormally low inventory levels during the past few quarters as against demand-driven growth.

Unless increased bank lending and government driven spending initiatives create enough employment, personal consumption expenditure would not pick up sufficiently to drive back demand for products and services. This, along with a sustained uptick in both personal and business confidence indices, is required to pave the way to recovery over the next few quarters.

Finally, i personally think that we are more on the way to a 'New normal' as against the pre-crisis economy - as I opined in the previous article too. The impact created due to the crisis is significant enough to affect long-term trends in spending and saving patterns, if not financial services lending patterns too! This will prevent a drastic v-shaped reversal hoped by early-mover market bulls. However, there is enough initial momentum to continue a path to recovery and hence there is no reason to expect a decline of market indicators back to the Q1 2009 levels. From a numbers perspective, assuming continued Fed and government support, I would rather bet on a slow, but volatile climb of the DJIA to 11,000 levels by Q3 2010 as against a move to 7000 or a 14000!

Due to the same reality, there is not enough fundamental strength for the drastic surge in retail stocks. Manufacturing stocks should see a tempered rise while home builder stocks, especially luxury builders, have quite a way to go before high multipliers are justified. I would personally bet on financial services picks with healthier balance sheets or consumer non-durables, and not retail at this point!