Among the many reforms in the aftermath of the financial crisis is the agreement among international regulators that all over-the-counter (OTC) derivatives contracts should be reported to trade repositories. The goal is to help market participants and regulators gain a better understanding of the extent and distribution of risk taking in financial markets. G-20 leaders committed to this and other improvements to financial market infrastructure (we described the move to central clearing parties (CCPs) in earlier posts). But, unlike the shift to CCPs, trade repositories seem very unlikely to meet officials’ lofty aspirations in the next few years.
As economists (and small “d” democrats), we are reflexively in favor of transparency. So, the burden lies on us to explain any doubts about a mechanism aimed at improving the reporting of financial market activity.
Indeed, the push behind trade repository reporting is a noble one. Connections between financial intermediaries created by derivatives contracts are very hard to track. This lack of transparency makes it relatively easy to conceal concentrations of risk from potential trading partners, who usually charge an elevated risk premium to risky counterparties, and from the authorities, whose job it is to scrutinize the riskiness of systemic intermediaries. Without such opacity, it is doubtful that AIG could have accumulated nearly $450 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS) prior to the financial crisis of 2007-2009. The opacity can be so severe that even the top managers of intermediaries may not know about their own institution’s exposure (recall JPMorgan’s London Whale).
Now, imagine that somewhere someone was collecting, constructing and distributing in real time a giant exposure matrix for all derivatives traded and all the market participants trading them. The matrix would map all the positions taken by anyone who has bought or sold any derivative. In a perfect world, this giant risk map would allow us to discern where risk concentrations are lurking in the system and how big those concentrations are. The map could help pinpoint the next AIG before it did any damage.
Naturally, it would be great to arm traders and regulators with such reliable, up-to-date knowledge about risk taking. However, there is a world of difference between this ideal real-time risk map and the trade repositories currently under construction. A real-time map that reveals risk exposures requires the following information as soon as a trade occurs: who bought the instrument, who sold it, exactly what the contract says, the quantity and price agreed, the collateral that is posted to ensure performance, and the related margins held in accounts at derivatives brokers. More technically, we need legal entity identifiers (LEIs), securities identifiers, and detailed information regarding quantities, prices, collateral, and margins. With that data in hand, we could construct the network of exposures and look for systemic risks.
Fortunately, regulators have made progress toward solving the LEI problem. As a result of a global agreement, there now exists a Legal Entity Identifier Regulatory Oversight Committee developing a system to issue LEIs. Unfortunately, there is no analogous securities identifier system being created – that is, no global equivalent to U.S. CUSIP numbers. (CUSIP stands for Committee on Uniform Security Identification Procedures.) No less important, there is no mechanism for reporting details about the collateral posted in association with a given derivatives contract. The information reported today is just the notional amount and a market price.
Finally, because positions and exposures change by the minute (or even by the second), the complete reporting, data aggregation and information distribution process would have to be done in real time to generate an up-to-date risk map. Providing only a subset of this information (absent collateral details and universal securities identifiers) on a quarter-end basis, as is currently envisioned, would merely encourage window-dressing by risk-taking intermediaries at the key reporting moments.
In theory, we can imagine a trade repository system capable of meeting the goals that the G-20 had in mind in 2009. Unfortunately, those objectives remain disappointingly remote, leaving us concerned that large systemic risks will again be overlooked by counterparties and regulators alike. No wonder we welcome FRB Chairman Janet Yellen’s hint of support last month for higher capital requirements on large banks.