Regulating the Shadow Banking System, Part Two

Learning How to Swap

“Extra time granted” on over-the-counter derivative reform in response to dealer complaints, so reports the FT. At stake, and at issue, is the Dodd-Frank call to move OTC derivatives into clearing arrangements for reasons of pricing transparency as well as safety. And it is not just the dealers pushing back, but also the European Commission and the U.S. Treasury. What is going on?

Let’s start at the beginning, with the fundamental notion of a swap.

In its essence, all banking is nothing more than a swap of IOUs. I give my banker a sheaf of papers that say, essentially, “I owe you $100,000”, and my banker gives me a deposit account that says the same. The result is an alchemical conversion of my uncertain future earning prospects into current spendable cash.

Although the present value of the two IOUs is the same, the future value is not. The difference is the source of my banker’s expected profit, and also of my banker’s risk that is compensated by that profit. Most immediately there is liquidity risk, since likely I will be transferring my deposit to someone else, so triggering a reserve outflow for my banker. In the longer run there is solvency risk, since my banker is on the hook for the transferred deposit even if I fail to repay my loan, or if rates rise so that my loan falls in value.

Traditionally, the art of banking is the art of managing these risks, for example by using diversification to manage credit risk, or using liability duration matching to manage interest rate risk. In modern banking, swap contracts are used for the same purpose. A credit default swap can be used to hedge credit risk, and an interest rate swap can be used to hedge interest rate risk.

The shadow banking system made extensive use of these swap contracts. That is why OTC derivatives reform is at the very center of any attempt seriously to grapple with the problem of regulating shadow banking. Dodd-Frank deserves credit for putting the issue on the table whether or not one agrees that the Dodd-Frank proposed solution is the answer.

As we get closer to the Dodd-Frank deadlines, it is becoming clearer how centrally important these reforms will be, and hence how important it is to get them right. In this way of thinking, it is good news that Brussels is taking a second look at the excessively cozy CDS clearing arrangements that have been set up by the biggest CDS dealers. “Improving fairness” is fundamentally about making these markets work better, rather than blindly banning them, and that means understanding them.

And it is definitely significant news that Geithner’s Treasury has moved to exempt foreign exchange swaps from Dodd-Frank, notwithstanding their role during the crisis. Assistant Treasury secretary Mary Miller states somewhat disingenuously: “Throughout the financial crisis the foreign exchange swaps and forward markets continued to operate.” Those who lived through the crisis will remember, to the contrary, that it was central bank cooperation, including the infamous liquidity swaps, that backstopped that market when it was ceasing to operate.

As I have emphasized in previous posts, shadow banking was about using wholesale money markets to fund private loans. But it was also about using derivative markets to manage the risk of those loans, and from this point of view the role of derivative dealers was critical.

CDS dealers, like dealers in any other security, make money by making markets, quoting one price at which they are willing to buy and another (higher) price at which they are willing to sell, and absorbing the resulting order flow onto their balance sheet. The ideal so-called “matched book” refers to a balance sheet in which short positions and long positions exactly offset, so that risk (other than counterparty risk) is eliminated and profit comes from the difference between the sell price and the buy price. In a decentralized market, dealers trade with one another to square up the book that results from client order flow. In a centralized clearinghouse, the counterparty for these trades is the clearinghouse itself.

Foreign exchange dealers similarly meet client demand and then trade among themselves to control the resulting risk exposure, but with one big difference. Central banks, whatever they may say in public, are typically not indifferent to the exchange value of the currency that they issue as their own liability. And they can do something about it, by trading in foreign exchange swaps and forwards for their own account. Transparency for the dealer goose would presumably mean transparency also for the central bank gander, a new thing and not perhaps an unmitigated good thing, at least from the standpoint of central bankers.

I conclude that we are sailing in uncharted waters, so it is probably a good idea to proceed with care. We are learning how to swap.

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