Thread: DERIVATIVE MARKET REFORM, Part 1 & 2

DERIVATIVE MARKET REFORM, Part 1
The folly of deregulation


By Henry C K Liu
Asia Times
Dec 3, 2009


On October 7, 2009, the United States House of Representatives Committee on Financial Services at long last held a public hearing on "Reform of the Over-the-Counter (OTC) Derivative Market: Limiting Risk and Ensuring Fairness".

OTC derivatives are contracts executed outside the regulated exchange environment whose values depend on (or derive from) the values of underlying assets, reference rates or indexes. Market participants use these instruments to perform a wide variety of useful risk management functions. The Bank of International Settlement (BIS) reports that the notional value of all outstanding OTC derivative contracts ending June 2009 was US$49.2 trillion worldwide against a 2009 world gross domestic product (GDP) of $65.6 trillion.

In the US, congressional hearings are the principal formal venue by which committees collect and analyze information in the early stages of legislative policymaking. The House Committee on Financial Services oversees and formulates policies and develops legislation that govern the entire US financial services industry, including the securities, insurance, banking, and housing industries. The committee also oversees the work of the Federal Reserve - the central bank - the Department of the Treasury, the Securities and Exchange Commission, and other financial services regulators and agencies.

As such, its mandate covers the OTC derivative market, which has been a major source of systemic risk in financial markets. The committee is at present chaired by Representative Barney Frank, Democrat from Massachusetts, with Republican Spencer Bachus from Alabama as ranking member.

Witnesses initially called by the committee for the hearing were all derivative industry representatives. The list included Jon Hixson, director of federal government relations at Cargill, an international provider of food, agricultural, and risk management products and services that relies heavily upon futures and OTC markets. Cargill is an extensive end-user of derivative products on both regulated exchanges and in the OTC markets. It also offers risk-management products and services to commercial customers and producers in the agriculture and energy markets.

Also on the list was also James Hill of Morgan Stanley, appearing on behalf of the Securities Industry and Financial Markets Association, Stuart Kaswell of the Managed Funds Association which, through one of its lobbyists, has delivered significant "bundled" donations to Congressman Frank. Another witness was Christopher Ferreri of the Wholesale Markets Brokers Association. All are or represent beneficiaries of deregulated derivative markets.

Robert A Johnson, director of financial reform at the Roosevelt Institute, was added as a witness at the last minute after protests made to Frank by Americans for Financial Reform, an organization of some 200 citizen groups advocating the interests of consumers, labor unions and small businesses. Johnson prepared an opening statement that focused, among other concerns, on the "structurally dysfunctional money politics system" that allows legislators to be improperly influenced by well-financed industry lobbyists and campaign contributions.

Johnson's point was validated by the fact that his opening statement was cut short by Congresswoman Melissa Bean, Democrat from Illinois, who chaired the meeting in the absence of Frank and whom Harpers Magazine described as "another industry-funded committee member". Johnson's written statement was kept off the committee's website on a manufactured technicality, presumably to suppress awkward public exposure of Wall Street financial support to Democratic legislators.

The draft of the reform bill that is the subject of the committee hearing fails to call for the establishment of a special exchange for OTC derivatives as proposed by some reformers. It proposes instead to establish a clearinghouse, which is a weaker vehicle for tracking OTC derivative transactions. But it also would allow banks and their counterparties to be exempted from posting such transactions to the clearinghouse if the parties do not wish to, by simply claiming that their derivative contracts do not fit into standardized formats enough to benefit from centralized clearinghouse practices.

An earlier draft of the bill would even have exempted transactions designed to hedge risk. Since practically all speculative derivative contracts contain elements of risk hedging, it would mean that essentially all derivative contracts could be exempted.

In an interview with Democracy Now, Johnson characterizes the reform bill as "too tepid, too weak, too late ... Very industry influenced. We had a crisis and they are pandering to the perpetrators."

All may not be lost. The legislation also has to pass the House Agriculture Committee, chaired by Congressman Collin C Peterson, Democrat from Minnesota, which is more likely to include a requirement that derivative contracts be traded on an exchange, or at least that banks and companies report their derivative contracts to a clearinghouse. "As things stand now, I'd be more inclined to support the Ag bill," says Frank.

Johnson, allowed to testify before Senate Agricultural Committee, reveals four major flaws in the financial sector.

Reform towards deregulation
Finance deregulation took a great leap forward with securities litigation reform after the Republicans captured the House of Representatives in November 1994 in president Bill Clinton's first mid-term election, which lost control of Congress to the Republicans.

The Private Security Litigation Reform Act of 1995 (PSLRA) was passed easily by a Republican-controlled Congress and, with Democrat support, even overrode a perfunctory presidential veto. The law was signed into law by a deeply wounded Democrat president who desperately needed Wall Street financial support to win a second term. It is a testimony to Clinton's political ingenuity that the orchestrated bipartisan veto allowed him also to avoid losing campaign donations from trial lawyers.

PSLRA was ostentatiously directed at aggressive security litigators, the most successful of whom was Bill Lerache, who had recovered billions for shareholders victimized by security fraud committed by management. Lerache and other partners in Milberg Weiss later pleaded guilty to making "false material declarations under oath" in federal court proceedings, allegedly intended to conceal $11.3 million in secret payments and kickbacks that the firm was said to have paid to named plaintiffs in more than 225 class actions suit in order to secure the standing to file the class action suits. Still, the suits that Lerache successfully brought were themselves of undisputable legal merit.

PSLRA made security fraud cases more difficult for plaintiffs to win. It reflected the belief prevalent among those in charge of the financial system that the market is the best self-regulating mechanism against fraud and abuse out of self interest, without the need for added legal constraints. Alan Greenspan, at the time the chairman of the Federal Reserve, Robert Rubin, the then secretary of the Treasury, and Arthur Levitt, the then chairman of the Security Exchange Commission, all were strong believers of the myth of market self-regulation and used their considerable influence to help create a deregulated regime in structured finance.

Skeptics of self-regulation
There were skeptics of market self-regulation. James S Chanos, head of Kynikos Associates, a short-selling hedge fund with $3 billion under management, was known for being the first to question Enron on its accounting fraud and for tipping Fortune magazine reporter Bethany McLean on it. He testified before the House Committee on Energy and Commerce on February 6, 2002, that PSLRA was responsible for the dramatic increase of fraud from 1995 through 2001 and that the statute "has emboldened dishonest managements to lie with impunity by relieving them of concern that those to whom they lie will have legal recourse. The Statute also seems to shield underwriters and accountants from [legal accountability for] lax performance." He added that "no major financial fraud in the United States in the last 10 years was uncovered by an outside accounting firm."

Financial innovation propelled the development of the derivative market, which in turn became a fertile field for abuses that have caused serial financial crises around the world since 1994, starting with the Mexico peso crisis and going on to the collapse of 233-year-old British firm Barings in 1995 from the billion-dollar loss incurred by derivative trader Nick Leeson, the 1997 Asian financial crisis detonated by the Thai central bank's inability to sustain the fixed exchange rate of the overvalued baht, and the 1998 financial crises in Russia and Brazil that froze global markets briefly and subsequently caused interconnected markets to crash in locked steps.

While each of these crises had it own particular roots, the vehicle that caused market failure in all cases was derivative trading.

Exchange traded and OTC derivatives
Derivatives tighten the connectivity between markets and enhance market efficiency, but they do this by increasing systemic risk globally if left unregulated.

Exchange traded derivative contracts are generally standardized, and investors are protected against fraud and default by transparency and the financial reserves of the exchange. OTC derivative contracts are uniquely structured and traded directly between contracting parties with full assumption of risk of counterparty default. Many large financial institutions, including big banks, generate handsome fee by acting as a private clearing houses for OTC derivative contracts. However, OTC derivatives traded by large financial institutions that also trade with other large financial institutions present systemic risk to the whole interconnected market.

Yet many policymakers and legislators still do not have a clear understanding of the nature of financial derivatives or how the derivative market actually works. While the destructive potentials of financial derivatives have been recognized since their invention 36 years ago, most regulators still lack the full understanding needed to design effective regulation for the derivative market, particularly the OTC derivative market. As a result, they tend to accept the myth of self-regulation as the best, albeit still imperfect, solution propagated by influential free market ideologues.

This is because the innovation-driven workings of the OTC derivative market are constantly evolving out of the public eye, making it difficult for anyone who is not a direct market participant in bilateral counterparty contracts to develop effective regulation to protect the financial system from derivative-induced systemic meltdown and to protect the general public from risks of loss.

Yet, bilateral derivative contracts are hedged through interconnection throughout the entire market. These contracts manage unit risk by transferring it to systemic risk. Thus regulation needs to be focused not just on size but also on the location of strategically placed fire breaks to prevent systemic contagion. Such systemic contagion can travel without even a direct physical connection. During the 1997 Asian financial crisis, speculators sold in strong but highly liquid market in futile attempts to save distressed position in illiquid markets, bringing the entire global market down.

Individually benign, systemically dangerous
Derivatives, whose values are derived from underlying assets, are not by themselves toxic financial products invented by evil financial wizards. They are rational instruments for unlocking latent value in financial transactions through mathematical logic.

With precise measurement of derived value and immaculate logic in risk management, full potential net value can be effectively captured for both the participating parties and the economy as a whole that otherwise would be left untapped in conventional financial transactions. By definition, value creation is a positive contribution, but only net value creation after taking into account risk of loss can be a positive economic contribution. Creating or capturing value via unknown risk is merely gambling with luck.

Derivatives, by their opaque nature, only hide risk by dispersing it, but not by extinguishing it, allowing the risk to stay invisibly in the system, thus creating a false sense of safety. Such instrument structurally under-price risk by only hiding it. (See The Danger of Derivatives, Asia Times Online, May 23, 2002.)

A derivative, being a financial instrument that derives its value from an underlying asset, is a sophisticated vehicle for pricing derived values that are affected by market risks. Rather than trading or exchanging the underlying asset itself, derivative traders enter into contractual agreements to exchange cash flow, or assets of equivalent value, over time based on expected future value of the underlying assets. A futures contract is an agreement to exchange the value of an assumed underlying asset at a future date, but not necessarily the physical asset itself. Thus was born the concept of notional value in derivative structures.

The use of leverage
To capture minute change in value, derivatives are routinely structured with high leverage, so that a small movement in the value of the underlying asset can cause large changes in the value of the derivative contract. This leverage, coupled with the astronomical growth of the OTC derivative market, has turned many financial institutions that participate in this market into "too big to fail" entities, the failure of which can cause serious systemic impact, allowing them to expect government bailout by holding the financial system hostage in a distressed market to prevent systemic collapse.

Thus the "too-big-to-fail" syndrome leads directly to heightened moral hazard. Still, leverage is the music of the derivative market. Without access to leverage, the derivative market will have no dancers.

The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1. After the rule was exempted in 2004 for five big firms, many hedge funds increased their leverage to 40-to-1 to maximize profit by enlarging the risk profile by trading with the big five. (See The zero interest rate trap, Asia Times Online, January 22, 2009.)

Moral hazard generated by the "too-big-to-fail" syndrome distorts the risk management role of derivative structures. It turns the hedging function of derivative into profit centers derived from an under-pricing of risk for unsustainable gains.

The solution to the "too-big-to-fail" dilemma intuitively lies in preventing institutions from getting too big. Yet because of the interconnection of markets, even failure of small entities in large numbers can trigger systemic failure. This gives even larger numbers of small entities of similar risk profile, but each not too big to fail individually, the ability to cause systemic failure.

In mathematics, the theory of large numbers includes the phenomenon of unsustainable exponential growth, which occurs when the growth rate of a mathematical function is exponentially proportional to the function's escalating value. Such exponential growth is mathematically unsustainable and will eventually implode. Malthusian population theory is based on the un-sustainability of exponential growth.

Multilevel marketing is designed to create a fast-growing marketing taskforce by compensating not only for sales it generates but also for the sales of other new marketing taskforces introduced to the company by each existing marketing taskforce, creating a limitless down-line of distributors and a hierarchy of multiple levels of compensation in the form of a pyramid, such as that employed by Amway Corporation. The crisis in subprime mortgage was caused by massive network marketing, even as each subprime mortgage individually is only a small contract.

No bank, however big and well capitalized, can withstand the onslaught of a systemic breakdown of market-wide counterparty exposure built by multilevel marketing of liabilities such as subprime mortgages and their securitization.

Thus the problem of systemic market failure is caused not merely by unit bigness, but also by the absence of firebreaks to prevent exponential growth and the resultant systemic contagion effect of large number failures from chained counterparty reaction. It is hard to understand why policymakers are not cognizant enough of this obvious fact to focus on the need for firebreaks in interconnected financial markets, both to prevent the buildup of risk chain reaction and to contain systemic failure contagion.

Options and hedges
In finance, options are derivatives because they derive their value from an underlying asset. An option contract is an agreement between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset on or before the option's expiration date at an agreed price. In return for granting the option, the seller collects a payment or a consideration from the buyer.

Options can be used to speculate for profit or to hedge risk. The classic model of hedging, originally developed in 1949 by Alfred Winslow Jones (1910-1989), takes long and short positions in equities simultaneously to limit exposures to volatility in the stock market.

Jones, an Australian-born, Harvard and Columbia educated sociologist turned financial journalist, came upon a key insight that one could combine two opposing investment positions simultaneously: buying stocks and selling short paired stocks, each position by itself being risky and speculative, but when properly combined would result in a conservative portfolio that could yield market-neutral outsized gains with high leverage.

The realization that one could couple opposing speculative plays to achieve conservative ends was the most important step in the development of hedged funds, a term coined by a 1966 article in Fortune to describe the fund run by Jones.

The manipulative power of options lies in their versatility. Options enable the buying party to adapt or adjust its position to handle any future situation that may arise. Options can be used speculatively with risk or protectively against risk to fit the buyer's desire. This means an option buyer can do everything from protecting a position from decline to outright betting on the movement of a market or index for gain. Options are therefore merely passive versatile financial instruments. The users of options determine their purpose for their use.

Regulating the options market has all the controversy of the debate on gun control. Guns do not kill; only people kill; but guns make it easier for people to kill. Thus gun control is advisable even though it is not a final solution to purposeful or accidental killing. Further, guns should definitely be kept away from children who have not developed the mature faculty to handle a dangerous weapon properly. Similarly, the trading of options should be regulated to keep investors who do not fully understand the implications of their investment decisions by the use of options.

To facilitate varying cash flow needs of different participants in a transaction, payments can take the form of structured settlements, which are agreements to pay a designated party a specific sum in periodic payments over an extended period, sometimes for a lifetime without definitive end, instead of a lump sum. The risk on the uncertain aggregate payout amount is assumed inherently by the design of the structure.

An option is a derivative whose value changes over time in relation to the performance of the underlying asset such as a stock. This makes the precise evaluation of outstanding value of options difficult for the human mind to decipher in a timely manner, making risk-managed trading problematic.

Options and Futures
A more complex version of an option is a futures contract, where the value varies with the value of an underlying commodity or security. A futures contract commits a party to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The contracts are traded on a futures exchange and as such they are not over-the-counter derivatives that are traded outside of exchanges between counterparties directly.

Futures contracts are derivative instruments. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.

It is useful to understand that futures and option contracts are not market predictions, but market implications that have been precisely calculable since 1973. Futures and option contracts are extensively used to manage risks involved in holding interest-sensitive stocks of firms whose earnings are affected by interest rate changes, such as banks, insurance companies, financial companies, utilities or any enterprise that deploys large amounts of debt.

Black/Scholes/Merton Formula
In their 1973 paper, "The Pricing of Options and Corporate Liabilities", Fischer Black and Myron Scholes published an option valuation formula that has become the standard method of pricing options. Black and Scholes derived a stochastic partial differential equation governing the price of an asset on which an option is based, and then solved it to obtain their formula for the price of the option. Robert C Merton published a paper expanding the mathematical understanding of the options pricing model and coined the term "Black-Scholes" option pricing model. Merton and Scholes received the 1997 Nobel Prize for Economics for this and related work.

By providing a mathematical calculation for precise pricing of an option, changing it from involving mysterious intuitive guesses to a measurable rational implication, Black and Scholes made a path-breaking contribution to the growth of the option market.

Derivatives based on the yield performance of assets, interest rates, currency exchange rates and various domestic and foreign indices are now routine financial instruments that serve a wide range of risk management strategies.

A key characteristic of derivatives is their ability to exploit leverage, which when used knowledgeably, can enhance returns for investors with appropriate appetite for risk, or be highly effective in hedging portfolios through the neutralization of risk exposures. Black/Scholes merely made it possible to mathematically determine the precise and accurate price of an option, no more, no less. This simple feat in real-time accurate pricing in option markets was equivalent to the invention of accurate time-keeping in milliseconds in computer science. It opened up the possibility of building mathematical models that aim at profiting from managing risk.

A lot of people since Alfred Winslow Jones have known that pairs of opposite bets can cancel risks. What was lacking was the precision needed to identify the true pair opposites. Black/Scholes made it possible to precisely price every option trade in real time with a logic that the entire market accepts to be as reliable as the formula 2+2=4.

But the market for complex reasons is never 100% efficient or rational. One reason is the aggregate tendency to overcompensate due to the herd instinct. Too many correct moves that individually compensate accurately for local errors can lead to a big aggregate overcompensation for internally generated systemic error.

Black and Scholes found a partial solution to accurately price options in theory. But it was Merton at Harvard who completed the mathematical formula. Merton's father was a prominent behavioral scientist at Columbia who coined the concept of self-fulfilling prophecy. Merton studied mathematics at Cal Tech. Being mathematically trained and a gambler by instinct, (there were all kinds of stories about his gambling, how he would bet his annual salary in the market and live on loans collateralized by his holdings), Merton focused on prices in a series of infinitesimally minute time units, a process that came to be known as "continuous time finance".

In the 1970s, one could not read any current literature in finance without coming across reference to Merton's influential work. Merton translated the yet unpublished theoretical concepts of Black/Scholes by defining the relationship between an option and its underlying asset mathematically and came up with an elegant and easy-to-use formula that any college grad can use to trade options. But Merton, as a gentleman scholar, waiting for Black/Scholes to publish first.

At the time of Black/Scholes' publication, it was merely an academic theory, because there was not yet an operating options market. About three weeks before the B/S publication, the Chicago Board of Options Exchange began to list stock options for trading, but it was a very slow process. Not too long later, Texas Instruments came out with a hand-held calculator that had a Merton /B/S formula built-in. Soon, every young trader, many as second-year college drop-outs fresh from their first finance classes, was using a handheld TI calculator to trade options and was making more profit in a day than the college professors made in a year.

The derivative market took off. When B/S/Merton won the Nobel prize, young traders without exception were shouting "well deserved". No one could have used the B/S/Merton formula profitably before the advent of the options market, and the option market could not have taken off without the TI calculator with a built-in B/S/Merton formula. Financial innovation, similar to scientific and engineering innovation, evolves from a coincidence of related breakthroughs.

The Black/Scholes math-based models can sweep the market in seconds and identify inefficiencies and execute arbitrage trades to exploit market inefficiency. Derivative trades at first blossomed to reduce market inefficiency. It started as an exercise in portfolio insurance to mitigate risk, but as it became possible to mitigate risk, risk management actually allowed market participants to take on larger risk with a false sense of safety.

Risk management then soon became a profit center, leaving the insurance part behind. The profit advantage of each trade is often very minute, that is why it takes a huge number of trades, with notional values in billion of dollars to made sizable profit. Soon, the notional value market became exponentially larger than the physical market.

Credit default swaps
Credit default swaps (CDS) are contracts in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument goes into default. CDS contracts have been compared with insurance, but it is different in many aspects. For one, a buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. It is in a way similar to buying insurance on the death of a total stranger, which would be illegal in insurance.

According to the Bank for International Settlements (BIS), total outstanding credit default swaps (CDS) at year end 2007 was $43 trillion, more than half the size of the entire asset base of the global banking system. Total derivatives outstanding amounted to over $500 trillion in notional value, off the balance sheets of banks into those of special investment vehicles (SIVs) with collateralized debt obligations (CDOs) and other conduits comprising the highly leveraged shadow banking system.

July 2007 was the month the credit market imploded globally. US GDP was only $14 trillion in 2008. It will take the United States 36 years to produce $500 trillion in GDP.

Granted notional values are not the amount at risk. It is only a value on which derivative contracts calculate winning or losses. But a 3% net loss on a notional value of $500 trillion will wipe out the entire GDP in 2009. The fact that much of this frenzy of speculation was financed by debt made available by the loose monetary policy of the Alan Greenspan Federal Reserve was of course a key contributing factor that fueled the derivative market.

Heterogeneous expectation and efficient market hypothesis
Whatever else they were, Merton/Scholes were not charlatans. They were in fact astute philosophers of a finance technology revolution, managing risk by turning volatility against it, with the advantage of the law of large numbers within the context of the "Efficient Market Hypothesis", the central idea of modern finance and globalization.

The Theory of Heterogeneous Expectation asserts that asset prices can be affected by investor expectations to create market inefficiency and peculiarity. False expectation leads to price bubbles because the market for "longing" an asset is generally easier to make inside an exchange than a market for "shorting" it. This gives rise to the OTC market, where both long and short plays can be constructed at will.

Legal and exchange rules that place limitations on shorting gives exchange-traded prices an upward bias, allowing price bubbles long periods to build by negating the efficient market hypothesis. Also, the development of executive compensation through stock options rather than actual stocks means, in addition to potential dilution of stocks, that executive compensation is aligned with stockholder interest only when stock prices rise, but not when stock prices fall. Management began to enjoy the security of a separate lifeboat from risk than shareholders. When the down side of risk is removed from management, risk will be taken by management.

Proprietary trading
Every hedge fund uses its own proprietary models to exploit market inefficiency, but they are all based on the same logic of the market efficiency hypothesis. Derivative traders at first earned money only from incentive fees earned from trading profits made from hedging risks for clients. Soon traders became not satisfied with only the return they made from incentive fees from hedging for clients alone. They began taking proprietary speculative positions by entering into leverage funding agreements with banks and in time led banks to set up their own proprietary trading operations with off-balance-sheet risk exposure outside of their capital requirements.

In May 2002 I warned:
… assessment of risks is complicated by recent structural financial developments in the advanced nations' financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.

Even blue-chip global giants such as GE, JP Morgan Chase and CitiGroup have overhanging dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in derivatives enjoy exemption from commensurate risk premiums. (See BIS vs National Banks Asia Times Online, May 14, 2002).

The auto giants were not mentioned because even in 2002, they were no longer considered as blue-chip companies.

The Bank for International Settlements, which sets capital reserve requirements for banks, instead of focusing on balancing risk, developed Basel II to impose capital reserve on LCBOs against capital losses from high-risk derivative transactions.

Under Basel II, a bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as exposure at default (EAD), in the bank's internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure. In general, EAD can be seen as an estimation of the extent to which a bank may be exposed in the event and at the time of a counterparty default. It is a measure of potential exposure as calculated by a Basel Credit Risk Model for the period of one year or until maturity, whichever is sooner. Based on Basel guidelines, EAD for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs. The contagion effect of a chain of EAD is a key component that makes loss estimates difficult to pin down. (SeeCredulity caught in stress test, Asia Times Online, May 13, 2009.)

Banks used to set up derivative trades as a service to clients for a nominal fee. Then their bond trading departments began doing "proprietary" trading with the banks' funds, exposing banks to the potential of huge profits and risk of huge losses. By 2007, all banks had gotten into the derivative game up to their necks, as had all investment banks and even commercial banks. The profit potential of 40% returns annually was simply irresistible. Several central banks were also playing this game, some even today. The Bank of China was an investor in Long Term Capital Management (LTCM) as was the Central Bank of Italy. Both lost huge sums when LTCM collapsed in 1998.

The rise and fall of LTCM
No financial system can sustain returns of 40% perpetually. Such returns can only be produced by speculation. Thus the systemic risk was built into the system when derivatives were used to produce profit rather than to mitigate risk of loss. But immediate risk in the OTC derivative market is counterparty default. Counterparty risk could turn virtual winnings into actual losses, since it is a zero sum game.

Further, counterparty default can be highly contagious to detonate systemic consequences. That is the main reason the Fed was forced to bail out LTCM because LTCM was the counterparty to many of the banks' trades, in addition to being a big borrower. It was all very financially incestuous.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. LTCM board directors included Scholes and Merton. It accepted investments from 80 investors who put up a minimum of $10 million each. The initial equity capitalization of the firm was $1.3 billion.

Initially enormously successful, with annualized returns of over 40% after fees in its early years, LTCM's enormously leveraged arbitrage plays involving more than $1 trillion went bad in 1998, resulting in a $1.9 billion loss in one month, and a $4.6 billion loss in less than four months following Russian sovereign bond default. The final loss was $5.85 billion, a record at the time.

But six year later, in 2006, Amanranth Advisors lost $6.7 billion in gas futures placed by a star trader (Brian Hunter) and in 2008, Societe General lost $7.1 billion from trading fraud by a young trader (Jerome Kerviel) in European Index futures. The trend suggests that no lessons have been learned about the failure of market self regulation.

LTCM's extensive derivative contracts with banks and other institutional investors worldwide threatened a global market seizure if it should default on its obligations, which prompted the Federal Reserve Bank of New York to step in to organize a bailout with the affected major banks. The fund folded in early 2000, but the real damage was an increase of moral hazard in the finance industry.

Meriwether had assembled an all star-team beyond theoretical gurus at the founding of LTCM, including David Mullins, a vice chairman of the Federal Reserve and expert on financial crises, who wrote the White House Report on the 1987 crash, blaming it on derivatives. He also served as assistant secretary of the Treasury for domestic finance in the George HW Bush administration. When disaster hit, Mullins through his old connections brought in the Fed for a quick bailout.

Merton and Scholes were not actually doing the trading for LTCM. They only provided the theoretical strategy. They did not see LTCM as a mere hedge fund, but as a state of the art "financial intermediary", a new generation of shadow banking. Unlike old fashioned banks that dealt with clients they personally knew, LTCM remotely matched liabilities with assets globally in a virtual market, rather than locally as banks used to do as pillars of their communities.

LTCM borrowed by selling one bond and lent by buying another bond, often foreign bonds with different fundamentals, and profited from the spread in both interest rates and currency exchange rates. Most of the time LTCM traders did not know, or did not care, who were the final sellers or buyers, as long as the trades were channeled through acceptable broker/dealers and properly hedged. LTCM was in the highly profitable business of enhancing global market efficiency and of providing liquidity to the market. It had no loyalty to any particular nation or community, working solely on the principle of survival of the fittest.

At the end, LTCM was brought down by an irrationally inefficient market when Russia defaulted on her sovereign bonds because Washington refused to come to her aid and by a mega-liquidity crunch that LTCM itself could not provide for.

LTCM employed complex mathematical models to take advantage of fixed-income arbitrage deals through a strategy of convergence trades of Group of Seven sovereign bonds. Government bonds are "fixed-term debt obligations" because they will pay a fixed amount at a specified time in the future. Differences in the present value of different bonds are minimal, as according to equilibrium theory any difference in price will soon be eliminated by arbitrage.

Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a new 30-year Treasury bond and a 29-and-three-quarter-year-old Treasury bond should be minimal, as both will see a fixed payment roughly 30 years in the future. However, small discrepancies can arise between the two bonds because of a difference in liquidity.

By a series of financial transactions, essentially amounting to buying the cheaper "off-the-run" bond (the 29-and- three-quarter-year-old bond) and shorting the more expensive, but more liquid, "on-the-run" bond (the 30-year bond just issued by the Treasury), it would be possible to make a profit as the spread in the value of the bonds narrowed when another new bond is issued. On this principle, LTCM scored huge profits with high off-balance-sheet leverage achieved with sophisticated and complex hedges. It also invested in long positions in emerging markets sovereigns, hedged back to dollars.

As LTCM scored enviable returns, its capital base grew beyond the market for profitable bond-arbitrage trades. To maintain market expectation of high returns on assets under management, LTCM was pressured to undertake more aggressive trading strategies. Although these trading strategies were non-market directional, that is, they were not dependent on overall interest rates or stock prices going up or down, meaning they were market neutral, they were no longer strictly pure convergence trades, but convergence trades subject to exogenous impacts.

By 1998, LTCM had very large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had also become a major supplier of S&P 500 vega, which measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of the underlying asset, and was in demand by companies seeking, essentially, to insure equities held against future declines.

Because these differences in value were minute - especially for the convergence trades - LTCM needed to take highly leveraged positions to make profits of consequence. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed more than $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. It had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equal to 5% of the entire global market. LTCM also invested in other derivatives such as equity options.

After two years of returns running close to 40%, the fund had some $7 billion under management. But by the end of 1997, LTCM was achieving only a 27% return, comparable with the return on US equities that year. LTCM returned $2.7 billion of the fund's capital back to investors citing as reason "investment opportunities were not large and attractive enough". This was a strategic error, as the reduction of capital adversely affected LTCM's ability to withstand a liquidity crisis a few months later.

Trouble at LTCM began in May and June 1998 when net returns fell to minus 6.42% and minus 10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the distressed exit of Salomon Brothers from the arbitrage business in July 1998. There were signs that these losses could not be explained by temporary volatility.

LTCM's trading strategy finally unraveled in August and September 1998 when the Russian government defaulted on its sovereign bonds (GKOs). Panicked investors sold Japanese and European bonds to buy US Treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged from sudden market aversion of risk. By the end of August, LTCM had lost $1.85 billion in capital. The company, which had been providing annual returns of almost 40% up to this point, experienced a sudden and massive "flight to liquidity" by its investors.

The investors in LTCM were all sophisticated professionals - individuals who had made hundreds of millions themselves and sophisticated institutions who were major market players, including central banks. Central banks as a rule do not invest in hedge funds, yet LTCM was not simply another hedge fund, but a market leader in a new financial market. Barclays was also an investor as well as a big proprietary trader with its own account.

In fact, when swap spreads, the basic thermometer of the credit market, rose in late August, 1998, Barclay traders were ordered by top management to unload short positions in UK swaps, even though these traders, like those at LTCM, thought the higher spread could not hold and convergence would soon return. But Barclay had enough of risk and its decision on Thursday, August 20, pushed the spread even higher, and the next day the run started all over the world, and LTCM was facing imminent collapse.

LTCM had counterparty trades with nearly every institution of importance in the world, including all 15 largest commercial and investment banks. As LTCM teetered, Wall Street feared that its failure could cause a chain reaction counterparty default in interconnected markets around the world, causing catastrophic losses throughout the global financial system. As LTCM attempted desperately to raise needed cash on its own to honor its extensive commitments, it became clear to the market that a default was imminent.

The fear was that there would be a chain reaction as the firm liquidated its positions to cover its debt, leading to a sharp drop in prices, which would force other firms to liquidate their own debt creating a vicious cycle of fire sale.

On September 23, under the auspices of the NY Federal Reserve Bank, a group including Goldman Sachs, AIG, and Warren Buffet's Berkshire Hathaway offered to buy out LTCM partners for $250 million and to inject $3.75 billion to take over LTCM and fold it into Goldman's own trading division. The offer was stunningly low as at the start of the year LTCM partners' positions were worth $4.7 billion. Buffet gave Meriwether less than one hour to accept the deal. As it happened, the time period lapsed without a deal.

If LTCM had not returned $2.7 billion of its capital to investors, it might have been able to withstand the crisis.

Seeing no market options left, the New York Fed organized a bailout of $3.625 billion by 14 of the 15 LTCM major creditors to avoid a wider collapse in the financial markets: $300 million each from Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Solomon Smith Barney, and UBS; $125 million from Societe Generale; $100 million each from Lehman Brothers and Paribas; Bear Stearns alone declined to participate.

This refusal to play ball on the part of Bear Stearns would come back to haunt it in 2008 when Bear Stearns needed help to avoid collapse. Bear Stearns pioneered the securitization and asset-backed securities markets, and as investor losses mounted in those markets in 2006 and 2007, the company actually increased its exposure, especially the mortgage-backed assets that were central to the subprime mortgage crisis. The "Hail Mary" bet failed.

In March 2008, the New York Fed had to provide an emergency loan to Bear Stearns to try to avert a sudden collapse, but the firm could not be saved. The New York Fed then arranged for JP Morgan Chase to acquire Bear Stearns, with a Fed guarantee, for as low as $10 per share, far below the 52-week high of $133.20 per share before the crisis, although not as low as the $2 per share originally agreed upon by Bear Stearns and JP Morgan Chase without a Fed guarantee.

In return for bailing out LTCM, the participating banks received 90% of LTCM shares and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money reinvested in LTCM, all of which was wiped out.

LTCM's total losses added up to $4.6 billion. The losses by major investment categories were: $1.6 billion in swaps, $1.3 billion in equity volatility, $430 million in Russia and other emerging markets, $371 million in directional trades in developed countries, $286 million in equity pairs (such as VW, Shell), $215 million in yield curve arbitrage, $203 million in S&P 500 stocks, $100 million in junk bond arbitrage and no substantial losses in merger arbitrage.

After the bailout, when the panic abated, the positions formerly held by LTCM were eventually liquidated at a small profit to the bailers. But the real damage was a sharp rise in moral hazard in the financial market that contributed to the crisis of 2007.

The profits from the LTCM trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio would be protected by diversification. However, the general flight to liquidity in late summer of 1998 led to a market-wide re-pricing of all risks and these separately leveraged positions all moved in the same direction, neutralizing the effect of balance in diversified portfolios. As the unanticipated correlation of LTCM's positions increased, the diversified benefits of LTCM's portfolio vanished and large losses to its equity value accumulated exponentially.

Value at risk as a risk-management tool
Thus the primary lesson of the 1998 crisis and the collapse of LTCM for value at risk (VaR) users is not one of liquidity, but more fundamentally that the underlying covariance matrix used in VaR analysis is not static but dynamic over time. LTCM was a victim of a massive "VaR break".

In financial mathematics and risk management, VaR is a widely used risk measure of the risk of loss on a specific portfolio of financial assets in terms of probability and time horizon. VaR is a threshold value of the probability that the mark-to-market loss in a portfolio over the given time horizon.

For example, a portfolio of stocks with a one-day 5% VaR of $1 million has a 5% probability that the portfolio will fall in value by $1 million over a one-trading-day period, assuming markets operate normally and there is no compensating trading by the portfolio. Operationally, a loss of $1 million on this portfolio can be expected on one day in 20. The portfolio is considered risk managed if over the 20-day period, the gain is over $1 million to cover the possible loss of $1 million. A loss that exceeds the VaR threshold is termed a "VaR break".

LTCM had a VaR of between $3 million and $5 million for any given day. In August 1998, its VaR rose 100 times to $300 million to $500 million for any given day. In the end, the basic convergence model used by LTCM remained operative in that the values of government bonds did eventually converge but only after the company had been wiped out.

Based on the derivative side of its books, LTCM had an astoundingly high debt-to-capital ratio. According to transcripts of the September 29, 1998, meeting, a desperate Peter Fisher, executive vice president of the NY Fed and account manager of the Fed Open Market Committee, told chairman Greenspan and other Fed governors: "The off-balance sheet leverage was 100 to 1 or 200 to 1 - I don't know how to calculate it."

Fisher went on to become under secretary for domestic finance of the Bill Clinton Treasury in 2001, and later in 2004 a BlackRock managing director and a member of the firm's management committee with primary responsibility for expanding the firm's balance sheet advisory services.

BlackRock is one of the world's largest publicly traded investment management firms, with employees in 21 countries throughout the Americas, Europe and Asia Pacific. As of 30 September 2009, BlackRock's assets under management total $1.435 trillion across equity, fixed income, cash management, alternative investment and real estate strategies, offering risk management, strategic advisory and enterprise investment system services to a broad base of clients with portfolios totaling approximately $7.25 trillion, almost half of US GDP.

The Sharpe Ratio
The Sharpe ratio (or reward-to-variability ratio), developed by William Forsyth Sharpe, is a measure of the excess return, or risk premium, per unit of risk in an investment asset or a trading strategy. The return on a benchmark asset, such as the risk-free rate of return, is the expected value of the excess of the asset return over the benchmark return. The standard deviation of the asset excess return is a constant risk-free return throughout the period.

The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken. When comparing two assets each with the expected return against the same benchmark risk free return, the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios. However, like any other mathematical model, it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns, but the inputs are false.

When examining the investment performance of assets with smoothing of returns, the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund's returns. Sharpe ratios are often used to rank the performance of portfolio or mutual fund managers.

The principal advantage of the Sharpe ratio is that it is directly computable from any observed series of returns without need for additional information surrounding the source of profitability. Unfortunately, some users are carelessly drawn to refer to the ratio as giving the level of "risk-adjusted returns" when the ratio gives only the volatility of adjusted returns when interpreted properly.

Given that a hedge fund manager typically aims for a Sharpe ratio of greater than 1.0, a commodity trading advisor (CTA) manager with a Sharpe ratio of 0.19 would do poorly under this criterion. A Sharpe ratio of 1.0 would suggest that the relevant percentage of return and risk is about even. A Sharpe ration of 2.0 is excellent but probably cannot be sustained for long.

But the Sharpe ratio has its own set of difficulties as a performance measure. In September 1996, after 31 months of operation, LTCM reportedly had a Sharpe ratio of 4.35 (after fees). With the benefit of hindsight, we can say that LTCM's realized Sharpe ratio after two-and-a-half years of operation did not give a meaningful indication of how to evaluate its investments.

LTCM started with $1.3 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities that are incorrectly priced relative to each other. Due to the small spread in arbitrage opportunities, the fund had to leverage itself highly to make money. At its height in 1998, the fund had $5 billion in capital, controlled over $100 billion of assets and had positions whose total worth was over a $1 trillion in notional value. Soon, it had to cut its capital down by more than half ($2.7 billion) without correspondingly reducing to risk exposure in an increasingly risk adverse market in order to maintain accustomed high return. All it did was to increase its Sharpe ratio.

Due to its highly leveraged nature and a financial crisis in Russia related to the default of sovereign bonds which led to a flight to quality, LTCM sustained massive losses and was in danger of defaulting on its extensive financial commitments. The size and breath of its positions made it difficult for LTCM to cut its losses in its positions without also wiping out still profitable positions. LTCM held huge positions in the market, totaling roughly 5% of the total global fixed-income market.

LTCM had borrowed massive amounts of money to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global market seizure and financial crisis, caused by the massive write-offs its creditors would have had to make. In September 1998 Fed-assisted bailout of LTCM prevented a systematic meltdown of the market at the last moment.

Volatility tends to come in lumps, as volatility tends to breed more volatility. The LTCM near collapse and the Russian debt crisis showed that high volatility would stay with the markets for extended time periods even after the precipitating events had subsided. Some market observers believe major volatility events tend to occur every four years, inherent in the structural dynamics of deregulated financial markets.

Next: The courageous Brooksley born

http://www.atimes.com/atimes/Global_Eco ... 3Dj02.html

DERIVATIVE MARKET REFORM, Part 2
The courageous Brooksley Born


By Henry CK Liu
Asia Times
Dec 4, 2009


This article concludes a two-part series.
Part 1: The folly of deregulation

In 2009, the John F Kennedy Profile in Courage Award, the nation's most prestigious honor for public servants, was given to Brooksley Born for her role in 1998, as chair of the Commodity Futures Trading Commission (CFTC), to try, albeit unsuccessfully, to bring over-the-counter financial derivatives under the regulatory control of the CFTC weeks before the collapse of Long-Term Capital Management (LTCM).

OTC derivatives are contracts executed outside of the regulated exchange environment and whose value depends on (or derives from) the value of an underlying asset, reference rate or index. Market participants use these instruments to perform a wide variety of useful risk management functions. The Bank of International Settlement (BIS) reports the notional value of outstanding OTC derivatives contracts ending June 2009 to be US$49.2 trillion worldwide against a 2009 world gross domestic product (GDP) of $65.6 trillion.

The award citation read:
The government's failure to regulate such financial deals has been widely criticized as one of the causes of the current financial crisis. In the booming economic climate of the 1990s, Born battled other regulators in the [Bill] Clinton administration, skeptical members of Congress and lobbyists over the regulation of derivatives, warning that unregulated financial contracts such as credit default swaps could pose grave dangers to the economy. Her efforts brought fierce opposition from Wall Street and from administration officials who believed deregulation was essential to the extraordinary economic growth that was then in full bloom. Her adversaries eventually passed legislation prohibiting the CFTC from any oversight of financial derivatives during her term. She stepped down from the CFTC in 1999 and returned to a distinguished career in public interest law.

Born, an attorney, was nominated as CFTC chair by Clinton on May 3, 1996, and confirmed by the Senate on August 2, 1996, to a term expiring April 15, 1999 and stayed on to serve as acting chair until she resigned on June 1, 1999.

At CFTC, Born conducted a financial analysis that led her to anticipate a serious financial crisis due to growth in the trade of unregulated derivatives. Born was particularly concerned about swaps, financial instruments that are traded over the counter on the dark market (trading on a cross network an alternative trading system that matches buy and sell orders electronically for execution without first routing the order to an exchange or other displayed markets, such as an Electronic Communication Network, which displays a public quote.

Instead, the order is either anonymously placed into a black box or flagged to other participants of the crossing network. The advantage of the crossing network to the transaction parties is the ability to execute a large block order without impacting the public quote. Swaps thus have no transparency except to the two counter-parties. The disadvantage to the market is that material information is hidden from market participants.

On May 7, 1998, the CFTC under Born issued a "Concept Release Concerning OTC Derivatives Market" requesting comments on whether the OTC derivatives market was properly regulated under the existing exemptions of the Commodity Exchange Act, a federal act passed during the New Deal era in 1936, and on whether market developments required regulatory changes.

Greenspan, Summers, Levitt oppose regulation
Financial regulation, even against fraud, was strenuously opposed by then Federal Reserve chairman Alan Greenspan, Treasury secretary Robert Rubin and undersecretary Larry Summers, who is now the top economic policymaker in the Barack Obama White House. On May 7, 1998, then Securities and Exchange Commission chairman Arthur Levitt joined Rubin and Greenspan in objecting to the issuance of the CFTC's Concept Release.

Their response off-handedly dismissed Born's concerns on inadequate regulation on the ground that discussing the regulation of swaps and other OTC derivative instruments would increase legal uncertainty of such instruments, potentially creating turmoil in the already adequately self-regulated markets and reducing the market value of these instruments. Further concerns voiced were that the imposition of new regulatory constraints would stifle innovation and push coveted transactions offshore through cross-border regulatory arbitrage.

In the Senate Agriculture Committee hearing on July 30, 1998, chairman Richard G Lugar, Indiana Republican, attempted to extract a public promise from Born to cease her campaign for regulation on the OTC derivative market in exchange for warding off a move in Congress for a Treasury-backed bill to slap a moratorium on further CFTC action.

To her credit, Born stood her ground, portraying her agency as being under attack for carrying out its statutory mandate by anti-regulation agencies, namely, the Fed, the Treasury and the SEC. Fed chairman Greenspan shot back angrily that CFTC regulation was superfluous, and that existing laws were quite adequate. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," Greenspan said, referring to OTC derivatives, adding, "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

According to Greenspan et al, the market can police itself even against fraud because it is run by honorable people who have strong incentives to protect the market from such fraud. But the issue at the hearing was more than bureaucratic turf war. It was an ideological battle with the full power of the Federal government siding with Wall Street to suppress the dutiful carrying out of the statutory mandate of a small agency to protect the general public. Born was effectively silenced by a concerted effort by top officials in the Clinton administration after she responded to a challenge from a committee member on what she was trying to protect by saying: "We're trying to protect the money of American public."

Summers then as Treasury undersecretary, now top economic policymaker in the Obama administration, was reportedly the Clinton administration's hatchet man to shut up Born and shut down CFTC demands for regulation of the OTC derivatives market. Born resigned as head of CFTC on June 1, 1999, in frustration.

After the global financial crisis of 2008, Greenspan has since publicly confessed to Congress that he had erred in his judgment on the self-regulating power of the market. It is not known if he has apologized to Ms Born personally privately.

An October 2009 Public Broadcasting System Frontline documentary titled "The Warning" described Born's failed efforts to regulate and bring transparency to the secretive derivatives market, and noted the continuing resistance to reform. The program concluded with Born sounding another warning: "I think we will have continuing danger from these markets and that we will have repeats of the financial crisis - [they] may differ in details but there will be significant financial downturns and disasters attributed to this regulatory gap, over and over, until we learn from experience"

Wendy and Phil Gramm
Before Born, Wendy Gramm served as chair of CFTC from 1988 to 1993. Gramm is an economist and the wife of influential Republican Senator Phil Gramm of Texas. Responding to an intense lobbying campaign from Enron, the CFTC under Gramm exempted the energy trading company from regulation on energy derivatives trading that was to contribute to the eventual collapse and bankruptcy of the company in November 2001.

Wendy Gramm resigned from the CFTC in 1993 to accept a seat on the Enron board of directors and to serve on its audit committee, for which she received $1.86 million. While on the Enron board, she received donations from Enron to support the Mercatus Center at the conservative George Mason University on "market-oriented research, education, and outreach think tanks that work with policy experts, lobbyists, and government officials to connect academic learning and real-world practice."

The Mercatus Center was founded by Rich Fink, former president of the Koch Foundation, the philanthropic arm of Koch Industry, a private corporation based in Wichita, Kansas, with subsidiaries involved in core industries that range from commodities trading, petroleum, chemicals, energy, fiber, intermediates and polymers, to minerals, fertilizers, pulp and paper, chemical technology equipment, ranching, securities and finance, and other ventures and investments. In 2008, it was the second largest privately held company in the United States (after Cargill) with annual revenue of about $98 billion.

In 2001, the Office of Management and Budget (OMB) of the George W Bush White House asked for public input on which Federal regulations should be revised or suspended. Mercatus submitted 44 of the 71 proposals the OMB received. The recommendations from Mercatus attacked Federal regulations such as a proposed Interior Department rule prohibiting snowmobiles in Rocky Mountain National Park, a Transportation Department rule limiting truckers' consecutive hours behind the wheel without a rest, and a US Environmental Protection Agency rule limiting the amount of arsenic in drinking water, not because these regulations are bad for society, but that ideologically Mercatus believes such protection should not be imposed by government and that the people should have the right to chose for themselves whether they want to drink poisoned water.

The President's Working Group
The President's Working Group on Financial Markets (PWG), dubbed by a Washington Post headline as the "Plunge Protection Team", was created by executive order 12631 signed on March 18, 1988 by president Ronald Reagan after the financial crisis of 1987 to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence".

PWG is chaired by the secretary of the Treasury, or his designee; and members are the chairman of the board of governors of the Federal Reserve System, or his designee; the chairman of the Security and Exchange Commission, or his designee; and the chairman of the Commodity Futures Trading Commission, or his designee. Born was a PWG member by virtue of her position as chair of CFTC.

In April 1999, the PWG issued a report on the lessons of LTCM collapse, Born's last participation in the PWG before reigning two months later on June 1. The report raised some alarm over excess leverage and the opaque risks of the OTC derivatives market, but called for only one legislative change - a recommendation that unregulated affiliates of brokerages be required to assess and report their financial risk to government regulators. Fed chairman Greenspan dissented even on that vague recommendation on the ground that self-regulation was preferred.

Lessons of LTCM
Five months after the CFTC issued its Concept Release, CFTC chairperson Born gave a talk on October 15, 1998, entitled "Lessons of Long-Term Capital Management" at the Chicago Kent-IIT Commodity Law Institute in which she said: "The events surrounding the financial difficulties of Long-Term Capital Management LP ... raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and other institutions in the global financial markets. Most of these issues were raised by the Commission in its Concept Release on OTC Derivatives in May 1998. They include lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators."

On the lack of transparency, Born said: "While the CFTC and the US futures exchanges had full and accurate information about LTCM's exchange-traded futures positions through the CFTC's required large position reports, no federal regulator received reports from LTCM on its OTC derivatives positions. Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives users and about the nature and extent of their exposures potentially allows OTC derivatives market participants to take positions that may threaten our regulated markets or, indeed, our economy without the knowledge of any federal regulatory authority."

There are no requirements that a hedge fund like LTCM must provide disclosure documents to its counterparties or investors concerning its positions, exposures, or investment strategies. Even LTCM's major creditors did not have a complete picture of LTCM's financial health. A hedge fund's derivatives transactions have traditionally been treated as off-balance sheet transactions. Therefore, even though some hedge funds like LTCM are registered with the commission as commodity pool operators and are required to file annual financial reports with the commission, those reports do not fully reveal their OTC derivatives positions.

Unlike futures exchanges where bids and offers are quoted publicly, the OTC derivatives market has little price transparency. Lack of price transparency may aggravate problems arising from volatile markets because traders may be unable accurately to judge the value of their positions or the amount owed to them by their counterparties. Lack of price transparency also may contribute to fraud and sales practice abuses, allowing OTC derivatives market participants to be misled as to the value of their interests.

Transparency is one of the hallmarks of exchange-based derivatives trading in the US. Recordkeeping, reporting, and disclosure requirements are established by the Commodity Exchange Act and the commission's regulations; prices are discovered openly and competitively; and quotes are disseminated instantaneously. Positions in exchange-traded contracts are marked-to-market at least daily, thus ensuring that customers are always aware of the profit or loss on their positions. This transparency significantly contributes to the fact that US futures markets are the most trusted in the world.

A report in 1998 by the G-22 group of industrialized and developing nations called for improved transparency in both the public and private sectors, including an examination of the feasibility of compiling and publishing data on the international exposures of investment banks, hedge funds and other large institutional traders. Born maintained that, "If reporting and disclosure requirements had been in place in the US, some of the difficulties relating to LTCM might have been averted."

On the issue of excessive leverage, Born observed that "While traders on futures exchanges must post margin and have their positions marked to market on at least a daily basis, no such requirements exist in the OTC derivatives market."

LTCM managed to borrow approximately 100 times its capital and to hold derivatives positions with a notional value of approximately $1.25 trillion - or 1,000 times its capital. Indeed, it has been reported that LTCM generally insisted that it would not provide OTC derivatives counterparties with initial margin. LTCM's swap counterparties and other creditors reportedly did not have full information about its extensive borrowings from others and therefore unknowingly extended enormous credit to it.

Born warned that "This unlimited borrowing in the OTC derivatives market, like the unlimited borrowing on securities that contributed to the Great Depression, may pose grave dangers to our economy."

The CFTC Concept Release on OTC Derivatives describes many of the risk-limiting mechanisms of the futures exchanges, including mutualized clearing arrangements, marking to market, margin requirements, and capital and audit requirements. The Concept Release requests comment on whether similar protections are needed in the OTC derivatives market. Some market participants have already answered in the affirmative. Born suggested that "Clearing of OTC derivatives transactions could be a useful vehicle for imposing controls on excessive extensions of credit. It is essential for federal financial regulators to consider how to reduce the high level of leverage in the OTC derivatives market and its attendant risks."

Insufficiency of the internal controls applied by LTCM itself and its lenders and counterparties was another critical issue. The CFTC Concept Release on OTC derivatives calls for comment on a number of issues relating to the sufficiency of internal controls and risk management mechanisms employed by OTC derivatives market participants, including value-at-risk (VaR) models. LTCM now stands as a cautionary tale of the fallibility of even the most sophisticated VAR models. The prudential controls of LTCM's OTC counterparties and creditors, the parties that presumably had the greatest self-interest in assessing LTCM's financial wherewithal, also appear to have failed. They were reportedly unaware of the fund's extensive borrowings and risk exposures. US financial regulators urgently need to address these failures.

International regulators have expressed concern for some time about the lack of effective oversight of hedge funds and other large users of OTC derivatives and their ability to avoid regulation by any one nation in their global operations. Indeed, several emerging market countries have attributed crises in their currencies and markets to the actions of large hedge funds. The LTCM situation presented a new opportunity for the CFTC and other US regulators to work with authorities in other countries to harmonize regulation of the OTC derivatives market and to implement international regulatory standards.

The 1998 report by the G-22 was an important step in this direction and demonstrated a growing international consensus regarding the need for increased transparency. A study by the G-22 of how to implement reporting requirements was to proceed more or less in parallel with the President's Working Group study on the regulatory implications of the LTCM episode. Important work by the International Organization of Securities Commissions on the need for transparency and large position reporting related to exchange-traded derivatives was considered as useful to the G-22 study and the President's Working Group study on OTC derivatives.

Born concluded that "there is an immediate and pressing need to address possible regulatory protections in the OTC derivatives market. The LTCM episode not only has demonstrated the potential risks posed by the OTC derivatives market for the domestic and global economy, but also has highlighted the importance of the safeguards in place for exchange-traded futures and options. Obviously, regulation must be adapted to the particular marketplace and must address the risks to the public interest that that market poses. Thus, regulatory solutions for exchanges are not necessarily appropriate for the OTC market. Nonetheless, the markets involve similar instruments and pose many of the same risks, and our successful experience with the US futures exchanges will be invaluable in the study of the OTC derivatives market."

Congress overrules CFTC
In March 1999, Congress passed a law preventing the CFTC from changing its treatment of OTC derivatives. CFTC chair Born lost control of the issue at the CFTC when three of her four fellow commissioners announced they supported the legislation and would temporarily not vote to take any action concerning OTC derivatives. Thus defeated, CFTC chair Born resigned, effective later that summer. Her successor, William Rainer, was CFTC chair when the PWG Report was issued in November 1999.

Less than a decade later, with no regulatory reform accomplished since the LTCM collapse in 1998, a global financial crisis broke out in 2007.

In November 1999, Greenspan, Rubin, Levitt and Born's replacement at CFTC submitted a President's Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States".

Clinton signs repeal of Glass-Steagall
On November 12, 1999, a lame duck president Clinton signed into law the Gramm-Leach-Bliley Financial Services Modernization Act (GLBA), which repealed the Glass-Steagall Act of 1933, the New Deal era legislation designed to control financial speculation. GLBA reversed the Glass-Steagall separation of commercial and investment banks and allowed them to re-consolidate. The repeal of the Glass-Steagall Act, by combining the conflicting roles of lending institutions and security issuing institutions, facilitated the development of structured finance and debt securitization that contributed structurally to the 2007 credit crisis.

Phil Gramm, who began his political career as a Democratic congressman in the Texas populist tradition, changed party affiliation to become a neo-liberal Republican senator from Texas. As Republican chairman and ranking member of the Senate banking committee, he spearheaded the Gramm-Leach-Bliley Act of 1999 with the ideological conviction that higher bank profits commensurate with higher risk were the salvation of the US economy operating on the myth of market fundamentalism, reversing the age-old principle that banks as intermediaries of money should be the economy's most risk-averse institutions.

Between 1995 and 2000, Phil Gramm received more than $1 million in campaign contributions from the securities and investment industry, more than he received from oil and gas interests that traditionally were a key source of financial energy in Texas politics. After retiring from politics in 2002, Gramm became vice-chairman of the investment banking arm of Union Bank of Switzerland (UBS), an institution that by 2007 was in the spotlight for massive losses from subprime mortgage exposure. Gramm was an economic adviser to the presidential campaign of Republican candidate John McCain in 2007 before being dropped after he characterized the breaking financial crisis as merely an illusion of the whining public's "mental depression".

After the Enron scandal broke open in October 2001, Wendy Gramm and the other Enron directors were named in several investor lawsuits, most of which have since been settled. In particular, Wendy Gramm and other Enron directors had to agree to a $168 million settlement in a law suit led by the University of California, whose pension fund invested in Enron stocks that had lost all value from fraudulent transactions in OTC derivatives when Enron filed bankruptcy protection.

UC led a shareholder class action suit against Enron and its banks, alleging that internal Enron documents and testimony of bank employees detailed how the banks engineered sham transactions to keep billions of dollars of debt off Enron's balance sheet to create the illusion of impressive earnings and operating cash flow. As part of that settlement, Enron directors agreed to collectively pay $13 million to settle charges of insider trading. The remainder of the settlement was to be paid by the company's liability insurance.

The Gramm-Leach-Bliley Act opened up financial markets to merged entities of banking companies, securities companies and insurance companies. The Glass-Steagall Act that it repealed had prohibited any one institution from acting as any combination of investment banking, commercial banking, security firms and/or an insurance underwriting.

GLBA allowed commercial banks, investment banks, securities firms and insurance companies to reconsolidate vertically. An example was the merger of Citicorp (a commercial bank holding company) with Travelers Group (an insurance company) and the acquisition of Smith Barney (a brokerage) in 1998 to form the financial conglomerate Citigroup, a corporation combining banking, securities and insurance services under a house of brands that also included Primerica. This combination, announced in 1993 and finalized in 1994, would have violated the Glass-Steagall Act and the Bank Holding Company Act of 1956 that forbade combining securities, insurance, and banking, if it were not for a temporary waiver process. GLBA legalized these mergers on a permanent basis.

President Obama has publicly expressed his belief that the GLBA directly helped cause the 2007 subprime mortgage financial crisis. Many economists have also criticized GLBA for not only having contributing to the 2007 crisis, but also under the present monetary system of fiat currency, GLBA promotes corporate welfare for financial institutions that are deemed "too big to fail" and a moral hazard that cost innocent taxpayers heavily. Nobel laureate economist Paul Krugman called Senator Phil Gramm, lead sponsor of GLBA, "the father of the [2007] financial crisis". Nobel laureate economist Joseph Stiglitz also argued that GLBA helped to create the financial crisis of 2007.

In response to criticism of his signing the GLBA as president, Bill Clinton said in 2008: "I don't see that signing that bill had anything to do with the current crisis. Indeed, one of the things that has helped stabilize the current situation as much as it has is the purchase of Merrill Lynch by Bank of America, which was much smoother than it would have been if I hadn't signed that bill. ... On the Glass-Steagall thing, like I said, if you could demonstrate to me that it was a mistake, I'd be glad to look at the evidence."

In February 2009, Senator Phil Gramm, wrote in defense of GLBA that: "... if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like JP Morgan, were the most diversified. … Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a super regulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB."

Neo-liberal economist Brad DeLong of the University of California, Berkeley, who deputy assistant Treasury secretary under Larry Summers in the last months of the Clinton administration, and conservative economist Tyler Cowen of George Mason University in Virginia and a director of Mercatus Center, both argue, albeit from opposing ends of the ideological spectrum, that the GLBA softened the impact of the financial crisis, notwithstanding the fact that GLBA contributed to the emergence of the financial crisis in the first place. An article in conservative National Review labeled liberal allegations about the GLBA causing the financial crisis "folk economics", which one assumes was intended as an elitist derogatory dismissal of populism for its lack of intellectual rigor.

In an interview on November 10, 2009, with The Daily Deal, H Rodgin Cohen, chairman of Sullivan & Cromwell, a law firm intimately involved with the repeal of Glass-Steagall, characterized blaming the repeal of certain provisions of the Glass-Steagall Act for the 2008 economic crisis as a myth. "Lehman, Bear Stearns, the GSEs [government-sponsored enterprises such as mortgage guarantor Fannie Mae], Washington Mutual, and Wachovia" had nothing to do with the repeal of Glass-Steagall," Cohen said, adding, "Much of the problem was the unregulated mortgage bankers and brokers, who ultimately polluted the system."

Commodity Futures Modernization Act
Throughout much of 2000, lobbyists for the OTC derivative industry were flying in and out of congressional offices. With Born gone from CFTC since June 1, 1999, they saw an opportunity to finally bury the regulatory issue. They had a sympathetic ear in senator Phil Gramm, who shepherded a deregulation bill, the 2000 Commodity Futures Modernization Act (CFMA).

The CFMA went beyond the recommendations of a Presidential Working Group on Financial Markets Report titled "Over-the-Counter Derivatives and the Commodity Exchange Act" (PWG Report), which was requested by the House and Senate Agriculture Committee chairmen in September 1998 and presented to the committee in November 1999. The committee's request for the PWG was "to conduct a study concerning the OTC derivatives market and provide legislative recommendations to Congress regarding whether these markets require additional regulation."

The PWG Report of 1999 was directed at ending controversy over how swaps and other OTC derivatives related to the 1936 Commodity Exchange Act (CEA), which replaced the Grain Futures Act of 1922.

CEA provided federal regulation of all commodities and futures trading activities and required all futures and commodity options to be traded on organized exchanges. In 1982, CEA created the National Futures Association (NFA), an independent self-regulatory organization and watchdog of the commodities and futures industry. The NFA oversees and protects investors from fraudulent commodities and futures activities and provides mediation and arbitration for resolving consumer complaints. NFA is headquartered in Chicago with an office in New York City. Its establishment represented a rising trend in favor of industry self-regulation over government regulation.

Before 1974, the CEA was applicable only to agricultural commodities. "Future delivery" contracts in agricultural commodities listed in the CEA were required to be traded on regulated exchanges such as the Chicago Board of Trade.

The Commodity Futures Trading Commission Act of 1974 created the Commodity Futures Trading Commission (CFTC) as the new government regulator of commodity exchanges. It also expanded the scope of the CEA to cover the previously listed agricultural products and "all other goods and articles, except onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in". Existing non-exchange traded financial "commodity" derivatives markets (mostly "interbank" markets) in foreign currencies, government securities, and other specified instruments were excluded from the CEA through the "Treasury Amendment", to the extent transactions in such markets remained off a "board of trade". The expanded CEA, however, did not generally exclude financial derivatives.

After the 1974 law change, the CEA continued to require that all "future delivery" contracts in commodities covered by the law be executed on a regulated exchange. This meant any "future delivery" contract entered into by parties off a regulated exchange would be illegal and unenforceable. The term "future delivery" was not defined in the CEA. Its definition evolved through CFTC actions and court rulings.

Not all derivative contracts are "future delivery" contracts. The CEA always excluded "forward delivery" contracts under which a farmer might set today the price at which the farmer would deliver to a grain elevator or other buyer a certain number of bushels of wheat to be harvested next summer. By the early 1980s, a market in interest rate and currency "swaps" had emerged in which banks and their customers would typically agree to exchange interest or currency amounts based on one party paying a fixed interest rate amount (or an amount in a specified currency) and the other paying a floating interest rate amount (or an amount in a different currency). These transactions were similar to "forward delivery" contracts under which "commercial users" of a commodity contracted for future deliveries of that commodity at an agreed upon price. The exception was that swaps were based on notional values with no exchanges required in actual physical commodities.

Based on the similarities between swaps and "forward delivery" contracts, yet without the burden of actual ownership or exchange of physical commodities, the swap market based on notional values grew rapidly in the United States during the 1980s. Nevertheless, as a 2006 Congressional Research Service report explained in describing the status of OTC derivatives in the 1980s: "If a court had ruled that a swap was in fact an illegal, off-exchange futures contract, trillions of dollars in outstanding swaps could have been invalidated. This might have caused chaos in financial markets, as swaps users would suddenly be exposed to the risks they had used derivatives to avoid."

'Legal certainty' through exemptions
To eliminate this legality risk, the CFTC and Congress acted to give "legal certainty" to swaps and, more generally, to the OTC derivatives market activities between "sophisticated parties."

The CFTC issued "policy statements" and "statutory interpretations" that swaps, "hybrid instruments" (that is, securities or deposits with a derivative component), and certain "forward transactions" were not covered by the CEA. The CFTC issued the forward transactions "statutory interpretation" in response to a court ruling that a North Sea Brent oil forward delivery contract was, in fact, a future delivery contract, which could cause it to be illegal and unenforceable under the CEA. This, along with a court ruling in the United Kingdom that swaps entered into by a local UK government unit were illegal, elevated concerns with "legal certainty".

Then, in response to this concern about "legal certainty", Congress through the Futures Trading Practices Act, or FTPA, of 1992 gave the CFTC authority to exempt transactions from the exchange trading requirement and other provisions of the CEA. In 1993, the CFTC under Wendy Gramm used that authority (as Congress contemplated or "instructed") to exempt the same three categories of transactions for which it had previously issued policy statements or statutory interpretations. The FTPA also provided that such CFTC exemptions preempted any state law that would otherwise make such transactions illegal as gambling or otherwise.

To preserve the 1982 Shad-Johnson Accord, which prohibited futures on "non-exempt securities", the FTPA prohibited the CFTC from granting an exemption from that prohibition. This would later lead to concerns about the "legal certainty" of swaps and other OTC derivatives related to "securities".

On September 1, 1999, the United States Court of Appeals for the Seventh Circuit by unanimous decision gave the Chicago Board of Trade (CBOT) permission to trade futures based on the Dow Jones Utilities Average and Dow Jones Transportation Average. This decision overturned a July 1998 decision by the Securities and Exchange Commission.

For the CBOT, this was a giant step towards its goal of eliminating the restrictions of the Shad-Johnson Accord. The Accord resolved a dispute between the SEC and the CFTC over regulation of index trading, granting the SEC the right to regulate stock index options and leaving stock index futures under the CFTC's jurisdiction. However, the SEC was given veto authority over stock index futures. The Court of Appeals basically ruled that the SEC misinterpreted the essence of the accord.

Similar to the existing statutory exclusion for "forward delivery" contracts, the 1989 "policy statement" on swaps had required that swaps covered by the "policy statement" be privately negotiated transactions between sophisticated parties covering (or "hedging") risks arising from their business (including investment and financing) activities. The new "swaps exemption" dropped the "hedging" requirement. It continued to require the swap be entered into by "sophisticated parties" (that is, "eligible swap participants") in private transactions.

Although the systemic danger of OTC derivatives had been subject to critical warnings in the 1990s and bills were introduced in Congress to regulate various aspects of the market, the 1993 exemptions by the CFTC under Wendy Gramm remained in place. Bank regulators issued guidelines and requirements for bank OTC derivatives activities that reflected some of the systemic concerns raised by Congress, the General Accounting Office and other agencies. Securities firms supported SEC and CFTC moves to establish a Derivatives Policy Group through which six large securities firms conducting the great majority of securities firm OTC derivatives activities agreed to report to the CFTC and SEC about their activities and adopted voluntary principles similar to those applicable to banks. Insurance companies, which represented a much smaller part of the market, remained outside any federal oversight of their OTC derivatives activities.

In 1997 and 1998 a conflict developed between the CFTC under Born and the SEC over an SEC proposal to ease its broker-dealer regulations for securities firm affiliates that engaged in OTC derivatives activities.

The SEC had long been frustrated that OTC derivatives activities were conducted outside the regulated broker-dealer affiliates of securities firms, often outside the United States in London or elsewhere of light regulation. To bring the activities into broker-dealer supervision, the SEC proposed relaxing net capital and other rules (know as "Broker-Dealer Lite") for OTC derivatives dealers. The CFTC objected that some activities that would be authorized by the SEC proposal were not permitted under the Commodity Exchange Act.

The May 7, 1998, concept release issued by the CFTC under Born sought public comments to assist the CFTC in reexamining its approach to the OTC derivatives market. The release was part of a comprehensive regulatory reform effort designed to update CFTC oversight of both exchange and off-exchange markets. CFTC hoped that the comments received would help it in assessing whether its then current regulatory approach to OTC derivatives was appropriate or should be modified.

In describing the CFTC action, Born stated: "The substantial changes in the OTC derivatives market over the past few years require the Commission to review its regulations. The Commission is not entering into this process with preconceived results in mind. We are reaching out to learn the views of the public, the industry and our fellow regulators on the appropriate regulatory approach to today's OTC derivatives marketplace."

The CFTC's last major regulatory actions involving OTC derivatives, adopted in January 1993 under chairperson Wendy Gramm, were regulatory exemptions from most provisions of the Commodity Exchange Act for certain swaps and hybrid instruments. Since that time, the OTC derivatives market has experienced significant changes and dramatic growth in both volume and variety of products offered, participation of many new end-users of varying degrees of sophistication, standardization of some products, and proposals for central execution or clearing operations.

While OTC derivatives serve important economic functions, these products, like any complex financial instrument, can present significant risks if misused or misunderstood. A number of large, well-publicized financial losses over the years between 1993, when the CFTC under Wendy Gramm exempted OTC derivatives from CFTC regulation, and May 17, 1998, the date of the CFTC Concept Release, had brought about the attention of the financial services industry, its regulators, derivatives end-users and the general public on potential problems and abuses in the OTC derivatives market. By 1998, many of these losses had come to light since the CFTC's last major OTC derivatives regulatory actions in 1993.

In view of these developments, the CFTC said it believed it was appropriate to review its regulatory approach to OTC derivatives. The goal of the reexamination was to assist it in determining how best to maintain adequate regulatory safeguards without impairing the ability of the OTC derivatives market to grow and the ability of U.S. entities to remain competitive in the global financial marketplace. In that context, the Commission said it was open both to evidence in support of broadening its existing exemptions and to evidence of the need for additional safeguards. Thus, the CFTC Concept Release identified a broad range of issues in order to stimulate public discussion and elicit informed analysis. The CFTC sought to draw on the knowledge and expertise of a broad spectrum of interested parties, including OTC derivatives dealers, end-users of derivatives, other industry participants, other regulatory authorities, and academicians.

The CFTC emphasized that it was mindful of the industry's need to retain flexibility to permit growth and innovation, as well as the need for legal certainty. CFTC said its Concept Release would not in any way alter the current status of any instrument or transaction under the Commodity Exchange Act. All currently applicable exemptions, interpretations and policy statements issued by the CFTC would remain in effect, and market participants could continue to rely on them. Any proposed regulatory modifications resulting from the CFTC Concept Release would be subject to rulemaking procedures, including public comments, and any changes that imposed new regulatory obligations or restrictions would be applied prospectively only.

The Concept Release sought comments on a number of areas where potential changes to the 1993 CFTC exemptions might be possible, including eligible transactions, eligible participants, clearing, transaction execution facilities, registration, capital, internal controls, sales practices, recordkeeping and reporting. The release also asked for views on whether issues described in the Concept Release might be addressed through industry bodies or self-regulatory organizations.

The CFTC actions were widely viewed as a preemptive response to the SEC's Broker-Dealer Lite proposal. Some even suspected such actions as perhaps an attempt by the CFTC to force the SEC to withdraw the "Broker-Dealer Lite" proposal. On May 7, 1998, the CFTC had openly expressed dismay over the SEC proposal and the manner in which it was issued, noting that the CFTC was 18 months into a "comprehensive regulatory reform effort." On the same day, the CFTC issued its Concept Release.

Immediately, three members of the Presidential Working Group - Rubin, Greenspan and Levitt, overruling the dissenting vote of Born, issued a letter asking Congress to prevent the CFTC from changing its existing treatment of OTC derivatives. They argued that, by calling into question whether swaps and other OTC derivatives were "futures" contracts, the CFTC was calling into question the legality of security related OTC derivatives for which the CFTC had not authority to grant exemptions (as described in Section 1.1.2) and, more broadly, the CFTC was undermining an "implicit agreement" not to raise the question of the CEA's coverage of swaps and other established OTC derivatives.

In the ensuing Congressional hearings, Rubin, Greenspan and Levitt argued that the CFTC was not the proper body, and that the CEA was not the proper statute, to regulate OTC derivatives activities. Banks and securities firms dominated the OTC derivatives market. Their regulators needed to be involved in any regulation on the market. The anti-CFTC members of the PWG explained that any effort to regulate OTC derivatives activities through the CEA would only lead to the activities moving outside the United States.

In the 1980s banks had used offshore branches to book transactions potentially covered by the CEA. Securities firms were still using London and other foreign offices to book at least securities related derivatives transactions. Any change in regulation of OTC derivatives should only occur after a full study of the issue by the entire PWG.

Born replied that the CFTC had exclusive authority over "futures" contracts under the CEA and could not allow the other PWG members to dictate or curb CFTC authority under that statute. She pointed out CFTC Concept Release did not propose, nor presuppose the need for, any change in the regulatory treatment of OTC derivatives. She noted, however, that changes in the OTC derivatives market had made that market more similar to futures markets.

The 1998 PWG Report recommended:

(1) The codification into the CEA, as an "exclusion", of existing regulatory exemptions for OTC financial derivatives, revised to permit electronic trading between "eligible swaps participants" (acting as "principals") and to even allow standardized (that is, "fungible") contracts subject to "regulated" clearing;

(2) Continuation of the existing CFTC authority to exempt other non-agricultural commodities (such as energy products) from provisions of the CEA;

(3) Continuation of existing exemptions for "hybrid instruments" expanded to cover the Shad-Johnson Accord (thereby exempting from the CEA any hybrid that could be viewed as a future on a "non-exempt security"), and a prohibition on the CFTC changing the exemption without the agreement of the other members of the PWG;

(4) Continuation of the preemption of state laws that might otherwise make any "excluded" or "exempted" transactions illegal as gambling or otherwise;

(5) As previously recommended by the PWG in its report on hedge funds, the expansion of SEC and CFTC "risk assessment" oversight of affiliates of securities firms and commodity firms engaged in OTC derivatives activities to ensure they did not endanger affiliated broker-dealers or futures commission merchants;

(6) Encouraging the CFTC to grant broad "deregulation" of existing exchange trading to reflect differences in (A) the susceptibility of commodities to price manipulation and (B) the "sophistication" and financial strength of the parties permitted to trade on the exchange; and

(7) Permission for single stock and narrow index stock futures on terms to be agreed between the CFTC and SEC.

In 1998, the disagreement between the CFTC under Born and the other three infinitely more powerful members of the PWG involved the scope and purposes of the CEA. The CFTC saw broad CEA purpose in protecting "fair access" to markets, "financial integrity", "price discovery and transparency", "fitness standards," and particularly protection of "market participants from fraud and other abuses." The other three members of the PWG, particularly the Federal Reserve through Greenspan, found the more limited purposes of CEA as (1) preventing price manipulation and (2) protecting retail investors. Other concerns such as fraud should be left to industry self governance.

The PWG report ended that disagreement by analyzing only four issues in deciding not to apply the CEA to OTC derivatives, by finding:

1. The sophisticated parties participating in the OTC derivatives markets did not require CEA protections;

2. The activities of most OTC derivatives dealers were already subject to direct or indirect federal oversight;

3. Manipulation of financial markets through financial OTC derivatives had not occurred and was highly unlikely, and

4. The OTC derivatives market performed no significant "price discovery" function.

The PWG concluded "there is no compelling evidence of problems involving bilateral swap agreements that would warrant regulation under the CEA".

The majority view of the three powerful members of the PWG concerning the scope and application of the CEA left the CFTC defenseless and permitted a "remarkable" agreement "on a redrawing of the regulatory lines".

Rather than treat the "convergence" of OTC derivatives and futures markets as a basis for CFTC regulation of OTC derivatives, the PWG report acknowledged and encouraged the growth in similarities between the OTC derivatives market and the regulated exchange traded futures market. Standardized terms and centralized clearing were to be encouraged, not prohibited. Price information could be broadly disseminated through "electronic trading facilities."

The PWG report hoped these features would:

1. Increase "transparency" and liquidity in the OTC derivatives market by increasing the circulation of information about market pricing, and

2. Reduce "systemic risk" by reducing credit exposures between parties to OTC derivatives transactions.

The report also emphasized the desire to "maintain US leadership in these rapidly developing markets" by discouraging the movement of such transactions "offshore".

In the 1998 Congressional hearings concerning the CFTC Concept Release, Representative James A Leach (Republican Iowa), the Leach of Gramm-Leach-Biiley Act, had tied the regulatory controversy to "systemic risk" by arguing that the movement of transactions to jurisdictions outside the United States would replace US regulation with more-lax foreign supervision. In other words, the US would compete in a global downward spiral of deregulation to keep its leadership in financial innovation.

The Commodity Futures Modernization Act of 2000 clarifies that most OTC derivative contracts would not be subject to regulation as the CFMA would bar the CFTC, the SEC, and the states from regulating these complex financial products between sophisticated parties.

The Enron loophole
Although the CFMA was hailed by the PWG on the day the act was given congressional passage (December 15, 2000) as "important legislation" to allow "the US to maintain its competitive [leadership] position in the over-the-counter derivative markets", by December 2, 2001, the bankruptcy filling of collapsed Enron brought public attention to the CFMA's treatment of energy derivatives in the "Enron loophole".

The Enron loophole is the nickname for the provision written into the CFMA of 2000 that was drafted by lobbyists for Enron and inserted in the bill by then senator Phil Gramm that deregulated an aspect of the market Enron sought to exploit with its "Enron On-Line" trading program, the first Internet-based commodities transaction system.

While it was a technical success, Enron On-Line was based on a flawed business model that drained corporate revenues - even while the company was manipulating the rates consumers paid for electricity in California. Enron On-Line eventually helped drive the company into bankruptcy, and the cooking of the books to hide its losses led to charges of conspiracy and fraud against Enron executives.

In the 1980s, Enron saw a profit potential in speculating on electricity futures if government regulation were remove to permit Enron to corner the market and game the market systematically. Then CFTC chair Wendy Gramm exempted Enron from CFTC regulation and made the exemption permanent before she left the CFTC on president Clinton's inauguration day.

After the 2000 presidential election, in the chaos of the constitutional crisis over which candidate had been elected president, Enron got a law passed containing what became known as the Enron loophole. Where the CFTC under Wendy Gramm deregulated individual trades, the loophole deregulated the entire online trading market which Enron had just started to focus on California.

In the first half of 2001, California suffered 38 rolling blackouts, as Enron legally used artificial shortages, bogus deals and total knowledge of the market as sole owner of its own online market to triple energy bills of California customers. CFTC regulators were totally in the dark as Enron traders laughed at the incompetence of the bureaucracy as the company raked in billions in ill-gained profits.

The Enron loophole applied to all energy commodities, oil, propane, natural gas, not just electricity. Even today, oil futures price are driven by speculators, free from any regulatory oversight. While Americans were told to blame oil producing nations in the Organization of Petroleum Exporting Countries for the high cost of oil, American homes had to pay billions more to speculators to heat their homes. In 2004, British Petroleum (BP) had to pay $303 million to settle charges it cornered the propane market to inflate heating costs for seven million American homes.

A Senate report recognized what speculators had done and attributed the abuse to the Enron loophole and the Senate Commerce Committee took testimony about the loophole‘s effect on the price of oil.

Enron and BP were not the only culprits. Morgan Stanley became the biggest heating oil speculator in New England. In 2006, Amanranth Advisors lost $6.7 billion in natural gas futures placed by a star trader (Brian Hunter). The speculative bubble in petroleum markets has been estimated in some quarters to have cost the average American household about $1,500 in increased gasoline, natural gas and electricity expenditures in the two years to 2008.

As early as 2002, John McCain voted with the minorities in the Senate to close the Enron loophole. "We‘re all tainted by Enron's money," he told the press. "Enron made a sound investment in Washington. It did them a lot of good. Where they really do well is around the edges, the insertion of an amendment, the Enron loophole, into an appropriations bill."

McCain's finance co-chair, Wayne Berman, lobbied for Chevron and for the American Petroleum Institute against the Price Gouging Prevention Act. The lobbying firm for which Berman now serves as managing director was hired by the New York Mercantile Exchange to lobby against the Close the Enron Loophole Act. McCain's top campaign adviser, lobbyist Charlie Black, was paid $140,000 by JP Morgan in 2000 to lobby Congress to pass the CFMA, which contained the Enron loophole.
During his presidential campaign, McCain focused on developing alternate energy sources rather than regulation. But unless regulated, the new, clean energy market will be cornered by big speculator banks which will rob those entrepreneurs blind as they have done to the gas station owners and heating oil dealers around the country. Candidate Obama also had an adviser who lobbied for the American Petroleum Institute.

The "Close the Enron Loophole Act" was a bill introduced by Senator Carl Levin (Democrat, Michigan) to amend the Commodity Exchange Act to close the Enron loophole, prevent price manipulation and excessive speculation in the trading of energy commodities, and for other purposes; it was never enacted into law to regulate more extensively "energy trading facilities".

CFMA and AIG
Following the Federal Reserve's emergency loans to "rescue" American International Group (AIG) in September, 2008, the CFMA received even more widespread criticism for its treatment of credit default swaps (CDS) and other OTC derivatives.

AIG provided insurance out of London in the form of credit default swaps on collateralized debt obligations (CDOs), tradable pools of cash-flow backed securities from mortgages, car loans and credit cards, without adequate capital reserves because insurance policies were not regulated in London. AIG had sold $440 billion in credit-default swaps tied to CDOs that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its CDS contracts to post billions in collateral that AIG had not provided for. When the market value of the CDOs started to fall as defaults mounted in the US, AIG had to start making additional collateral payments to its customers. By September 2008 it was running out of money.

The Fed took the highly unusual step using legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under "unusual and exigent" circumstances, an authority invoked six months earlier when Bear Stearns Cos. was rescued in March 2008. The $85 billion cash was used in part for AIG to meet additional collateral payments. Then, to draw a line under AIG's liabilities, the Fed bought out all the CDOs at their mark-to-market value, meaning that none of the counterparties lost a penny (collateral payments plus the market value of the CDOs summed to their face value).

A report prepared by Neil Barofsky, special inspector general for the Troubled Asset Relief Program, "Factors Affecting Efforts to Limit Payments to AIG Counterparties", criticized the New York Federal Reserve Bank for making "several policy decisions that severely limited its ability to obtain concessions from the counterparties".

The report criticizes the NY Fed for deciding against treating domestic banks that held AIG credit default swaps differently from foreign banks. That led France's bank regulator to refuse to allow two French banks involved to make concessions when negotiating the amount of payment for credit default swap obligations. The NY Fed failed to use what the report termed its "considerable leverage" over counterparties that it and the Federal Reserve regulated to force counterparties to accept reduced payments for the instruments.

The report also criticized the Federal Reserve for not revealing the identities of AIG's counterparties, which the Federal Reserve argued would undermine AIG and the stability of financial markets.
On August 11, 2009, the Treasury Department sent to Congress proposed legislation titled the "Over-the-Counter Derivatives Markets Act of 2009" (OCDMA). The Treasury Department stated that under this proposed legislation "the OTC derivative markets will be comprehensively regulated for the first time".

To accomplish this "comprehensive regulation", the proposed legislation would repeal many of the provisions of the CFMA, including all of the exclusions and exemptions discussed in Sections 4 above that have been identified as the "Enron loophole". While the proposed legislation would generally retain the "legal certainty" provisions of the CFMA, it would establish new requirements for parties dealing in "non-standardized" OTC derivatives and would require that "standardized" OTC derivatives be traded through a regulated trading facility and cleared through regulated central clearing. The proposed legislation would also repeal the CFMA's limits on SEC authority over "security-based swaps".

The proposed legislation would create new categories of market participants under the Commodity Exchange Act and directs the CFTC and the SEC to adopt joint interpretations of the defined terms, which includes "swap," "swap dealer," swap repository," and "major swap participant".

In response to the release of the Over-the-Counter Derivatives Markets Act by the Treasury Department, CFTC chairman Gary Gensler sent a letter to Congressional leaders with several amendments and clarifications to the legislation. These changes are intended to expand the CFTC's authority and to refine the legislation so that it covers "the entire marketplace without exception."

Under OCDMA, the definition of a swap subject to the statute will not include: any sale of a non-financial commodity for deferred shipment or delivery, so long as such transaction is physically settled; equity securities, or foreign exchange swaps or forwards. However, a currency swap will be considered a commodity swap under the proposed legislation, as are credit spreads, credit default swaps, and credit swaps. A major swap participant (MSP) is defined as an entity that is not a swap dealer but that maintains significant positions in outstanding swaps that are not for hedging purposes.

The proposed legislation requires federal banking regulators, the CFTC, and the SEC to impose strict capital and margin requirements on all OTC derivative dealers and MSPs. Federal banking regulators will have authority over banks that act as swap dealers and the CFTC and the SEC will have jurisdiction over non-bank swap dealers. Swap dealers and MSPs will be required to maintain prescribed levels of capital, daily trading records and records of their communications with counterparties, and will be required to comply with business conduct standards set by the CFTC: to disclose material risks of swap transactions; the source and amount of fees or remuneration that swap dealer/MSP would receive; and other material incentives/conflicts.

The CFTC and SEC will be required to "harmonize" their regulatory regimes for swap dealers and MSPs. The proposed legislation raises the significant concern that the definition of swap dealer or major swap participant could reach commercial entities whose working capital constraints will not allow them to meet these new capital or margin requirements.

For customized, bilateral contracts, the end-user will be required to post margin to the swap dealer and the relevant regulatory authority will perform audits of the dealer to ensure that proper margin is posted.

In turn, this may require additional legislative and/or regulatory changes to protect the margin posted by the end-user. Again, the narrow carve-out for non-financial entities using OTC derivative contracts to hedge price risk may limit or make customized OTC transactions inaccessible for non-financial entities that do not qualify for the limited exemption. (For those interested in source documents, see Notes below.)

Treasury Secretary Timothy Geithner, then as president and CEO of the NY Federal Reserve Bank, warned in a speech, "Risk Management Challenges in the US Financial System", before the Global Association of Risk Professionals 7th Annual Risk Management Convention & Exhibition in New York City on February 28, 2006 - 17 months before the credit crisis that broke out in July 2007 - that the scale of the over-the-counter derivatives markets was dangerously large.

"Although the notional total value of these contracts, now approaching $300 trillion, is not a particularly useful measure of the underlying economic exposure at stake, the size of gross exposures and the extraordinarily large number of contracts suggest the scale of the unwinding challenge the market would confront in the event of the exit of a major counterparty. The process of closing out those positions and replacing them could add stress to markets and possibly intensify the direct damage caused by exposure to the exiting institution," Geithner said.

Geithner observed that credit derivatives, where the gaps in the infrastructure and risk management systems were most conspicuous, were less than 10% of the total OTC derivatives universe, but were growing rapidly. Large notional values were written on a much smaller base of underlying debt issuance. The same names showed up in multiple types of positions - singles-name, index and structured products. These created the potential for squeezes in cash markets and greater volatility across instruments in the event of a default, magnifying the risk of adverse market dynamics.

The net credit exposures in OTC derivatives, after accounting for collateral, were a small fraction of the gross notional values. The 10 largest US bank holding companies, for example, report about $600 billion of potential credit exposure from their entire derivatives positions, the total gross notional values of which were about $95 trillion. That left more than $200 trillion of notional value to be reckon with outside the banking sector. This $600 billion "credit equivalent amount" exposure faced by banks was approximately 175% of tier-one capital, about 15% higher relative to capital than five years before in 2001.

This measure of the underlying credit exposure in OTC derivatives positions was roughly a fifth of the aggregate total credit exposure of the largest bank holding companies. This was a relatively conservative measure of the credit risk in total derivatives positions, but, for credit derivatives and some other instruments, it still might not adequately capture the scale of losses in the event of default in the underlying credits or the consequences of a prolonged disruption to market liquidity. The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.

Geithner allowed that internal risk management systems have improved substantially since the mid-1990s, but most firms still faced considerable challenges in aggregating exposures across the firm, capturing concentrations in exposures to credit and other risks, and producing stress testing and scenario analysis on a fully integrated picture of exposures generated across their increasingly diverse array of activities.

(Continued below)

The greater diversity of institutions that now provided demand for credit risk, or were willing to hold credit risk, should make credit markets more liquid and resilient than would be the case if credit risk was still held predominantly by banks or by a smaller number of more uniform institutions, with less capacity to hedge those exposures. However, the financial system still faced considerable uncertainty about how market liquidity would behave in the context of a major deterioration in credit conditions or a sharp increase in volatility in equity and credit spreads, and this uncertainty was hard to quantify and therefore hard to integrate into the risk management process.

Seventeen months later, such calm deliberations were drowned by a once-in-a-century collapse of the credit market.

The Obama administration has been trying to impose regulation on the OTC derivatives market. Led by Gary Gensler, the current CFTC chairman, the administration is proposing a bill that would establish an exchange on which derivatives, like stocks and bonds, could be traded. But the question is transparency, without which there will exist a huge information gap between the sellers and buyers of derivatives, making it impossible for regulators to gauge the level of systemic risk.

Yet the five biggest US banking institutions depend on that very information gap to create profit. Of the $291 trillion in notional value of all derivative contracts held by US institutions, 95% is held by the big five: JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Citigroup. In the first six months of 2009, in the midst of a deep recession, these banks made more than $15 billion trading derivatives. Transparency provided by trading in an exchange would eliminate much of the information advantages now enjoyed by the big five, as pointed by in congressional testimony by Rob Johnson, director of the Economic Policy Initiative for the Roosevelt Institute.

On September 28, 2009, the Office of the Comptroller of the Currency report on banks derivatives trading activities showed that the estimated value of all derivatives held by US commercial banks was rising, increasing nearly 1% over the last quarter and 12% year to year, to $203.5 trillion (total includes interest rate, foreign exchange, credit and other derivatives).

Bank holdings of credit default swap contracts remain greatly elevated. Although down from their peak in the fourth quarter of 2008, banks hold more than five times the amount in such derivatives than at the end of 2004, when the US economy was taking off. Banks exposure to derivatives, while falling slightly, remains alarmingly high. Bank of America's total derivatives-related credit exposure relative to its capital was 137%; Citibank 209% and Goldman Sachs 921%.

Trading credit derivatives is once again highly profitable. After seeing huge losses on these instruments toward the end of 2008 and into first quarter of 2009, banks generated $1.9 billion in cash and derivative revenue in the second quarter of 2009. That is problematic because regulatory reform is still stuck in congressional committees and subject to industry pressure not to spoil the party. As banks find it difficult to find creditworthy borrowers, they are using their funds to trade derivatives to drive profits. This new asset bubble, built by Fed funny money, unlike previous ones does not even bother to create an illusion of prosperity or full employment.

Once again derivatives are being used not to hedge risk but to generate unsustainable trading profit. Soon it will be deja vue. But first the world economy needs to recover from the current crisis which may not take hold until 2014. If history is any guide, around 2020 will be the time for the next market collapse.

Note
For those interested in source documents, click on the following for: The Over-the-Counter Derivatives Markets Act (OCDMA) ; The Treasury proposal; and The CFTC's proposal.

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