Market participants and officials acknowledge there are problems, if not instabilities, and weaknesses in OTC derivatives markets, and proposals and initiatives have been advanced. Some progress has already been made, and the lessons of recent experience are likely to motivate further actions. However, the available evidence suggests that many recognized problems have yet to be adequately addressed. Insufficient progress has been made in implementing reforms in risk management, including counterparty, liquidity, and operational risks.103 Relatively less attention has been focused on removing legal and regulatory uncertainty. Given the limited progress to date, it is essential to implement changes to reduce market instability.
Balancing Private and Official Roles
Many of the instabilities identified above can be seen as imperfections in three areas: market discipline, risk-mitigating infrastructures, and official rule making and oversight. Aspects of all three failed to prevent the buildup and concentration of counterparty exposures in 1998. Strengthening market stability requires improvements in each of these three areas, but consideration should also be given to altering the balance of the roles of the private and public sectors in ensuring market stability, in particular in tilting the balance in the direction of greater reliance on effective market discipline. It is in the general public’s interest to have these markets function as smoothly as possible most, if not all, of the time. This raises the more general question: what is the appropriate balance of market discipline on the one hand, and official oversight on the other hand, for ensuring the smooth functioning of OTC derivatives markets?
In striking this balance several factors are relevant. The authorities in the mature markets, primarily through G–10 efforts, have collectively more or less adopted an approach that places as heavy a reliance on market discipline as is feasible, while recognizing the limits to private discipline, including those emanating from moral hazard, information asymmetries, and other externalities. There is less agreement on the desirable degree of official involvement. Nevertheless, a strong case can be made for relying more heavily on market disciplining mechanisms provided they can be made more effective. There may also be areas of complementarities and scope for constructive engagement. One such area is disclosure; more voluntary and some involuntary disclosure might go a long way toward improving the effectiveness of risk management and market discipline through greater financial stakeholder awareness. But only the right kind of disclosure would improve mailers, and the international community is not clear about the kind or frequency of information that is required. Another consideration is that there are tradeoffs. For example, more official oversight or regulation, by creating the impression that officials are monitoring, can create moral hazard by diminishing private stakeholder incentives to monitor and influence business decisions and reduce management incentives for prudent risk taking. Striking the right balance needs to take account of these interrelated effects.
If it is desirable that market discipline carry the heaviest load, it would seem necessary to identify more rigorously the limits (natural or otherwise) that might exist to what the private sector can achieve on its own, against the background of existing rules of the game (supervisory and regulatory frameworks, including financial safely nets). A recent, but by no means unique, example of such a limitation is the private coordination failure that apparently occurred in organizing the private rescue of LTCM. By some accounts, in the days before it became clear that LTCM might default on some of its contracts, several large institutions apparently tried to organize a larger group of institutions to lake over the hedge fund. While some were willing to put up substantial amounts of capital, it was in the end insufficient. Moreover, it was also reported that several institutions with financial interests nevertheless decided they would not be a party to such a partnership. This example (of a free-rider problem) represents a limit to the ability of the private sector to ensure the smooth functioning of markets—by coordinating private solutions—in the presence of market stress.
There may also be limits to how far information asymmetries can be reduced. LTCM was widely viewed as a large source of trading revenues and information in 1996 and 1997. Each creditor institution can be viewed as having formulated an investment and trading strategy with LTCM that seemed desirable at the time given the limited information they had. In effect, institutions were involved in a dynamic game with LTCM and within the OTC derivatives markets: they provided financing for LTCM’s trades in return for trading activity and a window on LTCM’s order flow and investment strategy. Although it is easy, in retrospect, to question why LTCM’s counterparts did not demand more information, in a competitive environment, cost considerations must have weighed heavily. Clearly, LTCM’s counterparties thought the cost of more information was too high, and walking away from deals was not seen as in their interest. Moreover, they all thought they were receiving useful information from LTCM’s orders for trades.
Thus, situations can arise in which institutions in pursuit of self-interest can collectively produce market conditions that become unsustainable and harmful to them individually and collectively. That is, in the absence of a central, coordinating mechanism that enforces collective self-interest in market stability (such as on an exchange), individually desirable strategies, when aggregated, can produce bad market outcomes. Perhaps private information sharing and coordination could have made the LTCM game end without a severe disruption, but so too could have more effective official refereeing. The challenge is to have a framework that is more effective in preventing these situations from arising, and this involves assigning responsibilities to strengthen areas with potential instabilities.
Strengthening Incentives for More Effective Market Discipline
In some cases the assignment of responsibility is obvious. It is clearly the responsibility of private financial institutions to manage individual private risks, within the regulatory and supervisory framework. Well-known improvements (as discussed above and documented in several reports issued since the LTCM crisis) can be made in risk-management and control systems to enhance the likelihood that institutions will remain well capitalized and profitable and thereby help to avoid instability, even in limes of stress. The fact that market participants have not moved as quickly as might have been expected to improve risk management systems—given the virulence of the turbulence in the autumn of 1998—suggests that designing and implementing new systems to deal with the complex and evolving risks involved in OTC derivatives is a difficult challenge. On the other hand, while institutions have been slow to move ahead quickly with changes in risk management, there nevertheless is evidence that some of the major institutions are presently devoting less capital to market making in OTC derivatives markets and have also reduced proprietary trading.
Moral hazard, perhaps associated with national histories of market interventions, may be another factor impinging on the effectiveness of market discipline. The risk to financial stability arising from banks’ OTC derivatives activities may also be influenced by access to financial safety nets, which by imparting a subsidy element can influence the pricing of risk and thereby lead to overextensions of credit both on- and off-balance-sheet. Access to safely nets (including central bank financing) can give rise to incentives to take additional risks that can lead to the buildup of large, leveraged exposures which, when suddenly unwound, can precipitate a financial crisis of systemic proportions. Moreover, interventions during one stressful episode that limit losses can sow the seeds of the next buildup of exposures. These influences may have dampened the strong potential signal that institutions might have received from the turbulence that followed the near-collapse of LTCM.
It may be time to consider incentives that might be provided by the official sector to encourage the private sector to improve its ability to monitor itself, and to improve the effectiveness of market discipline. As emphasized in International Monetary Fund (1999),104 one way of improving the ability of private incentives to effectively discipline behavior is for the private and public sectors to jointly identify possible inconsistencies arising from the complex interplay of both private and regulatory incentives as they affect private decisions. Inconsistencies between private and regulatory incentives—for example, inconsistencies between internal models for allocating capital and regulatory capital requirements—could thus be rectified to alter behavior in ways that preserve efficiency and promote market stability.
Reducing Legal and Regulatory Uncertainty
There also seems to be an obvious assignment of responsibilities in the area of legal and regulatory uncertainty. The official sector and national legislatures can reduce legal and regulatory uncertainty. Legal or regulatory uncertainties that can be clearly identified should be addressed as soon as possible. Three areas immediately come to mind: the regulatory treatment of swaps and the implications for using private clearinghouses; closeout procedures; and netting. In each of these cases, reducing uncertainty could have the adverse consequence of actually increasing risk taking. To ensure that measures to reduce legal and regulatory uncertainty actually strengthen financial stability, it may be desirable, therefore, to link them to measures to address those features of OTC derivatives, institutions, and markets that most clearly pose risks to market stability. For example, legal certainty of closeout and netting would implicitly provide OTC derivatives creditors seniority over general creditors if a counterparty defaults. This could give rise to incentives to engage in riskier activities. To counteract such incentives, the extent of legally sanctioned closeout of contracts and permitted netting of exposures could be made contingent on key structural reforms that enhance stability. In this example, trading arrangements along the lines of a clearinghouse could be treated more favorably with respect to closeout and/or netting. More generally, the public sector should consider how steps to strengthen the legal infrastructure could help promote structural improvements in OTC derivatives markets. With these provisos in mind, the following considerations could potentially reduce the risk of market instability.
First, in the United States, the agencies supervising institutions and regulating markets (including the Federal Reserve System, the Treasury, the SEC, and the CFTC) agree that financial swaps ought to be exempt from CFTC supervision and regulation. The 1999 report by the President’s Working Group on Financial Markets on regulation of OTC derivatives recommended removing this uncertainty through legislative reforms that would grant swaps an exemption from potential CFTC oversight.105 This has been well received by the private sector, and work is underway, but limited progress has been made in this area. Resolving this issue with changes in legislation would clear the way for serious private consideration of reorganizing OTC derivatives markets, including taking advantage of many of the risk mitigating possibilities of a clearinghouse structure. Although legislation is under consideration in the U.S. Congress, some concerns have been expressed by the Federal Reserve Board, the Treasury, and the SEC about some features of this legislation, and it remains to be seen if the necessary changes will be passed into U.S. law.106
If the legal obstacles to a clearinghouse for OTC derivatives are removed, such an arrangement could mitigate risks associated with plain-vanilla swaps by handling clearing and settlement, formalizing and standardizing the management of counterparty risk through margin, and mutualizing the risk of counterparty default, and thereby reinforce market discipline and encourage self-regulation.107 Another question is whether market participants would need official encouragement to use a private clearinghouse. On the one hand, some market participants have expressed considerable skepticism about such an arrangement, and the clearing arrangements attempted thus far (such as SwapClear) have attracted little activity, in part because they are perceived to be costly, including relating to regulatory capital requirements. On the other hand, some market participants see a central clearinghouse as inevitable in view of the considerable operational difficulties of managing an OTC derivatives business, the challenges of managing credit risk on a bilateral basis, and the legal uncertainty of the OTC environment. In any case, if the regulatory environment is liberalized and the legal environment is clarified, this could accelerate the adoption of private electronic trading arrangements for swaps and other OTC derivatives (already in evidence in 2000) and may well give rise to de facto private clearinghouses.
Second, closeout procedures for derivative contracts have proven to be impractical and ineffective in some jurisdictions and under some market circumstances. Had they worked effectively, some of the adverse market dynamics in the LTCM crises might have been avoided. The uncertainty of their applicability might be clarified by the appropriate regulatory and legal bodies, including at the G–10 level if they involve more than one legal jurisdiction. The consequences of inaction could mean that virulent dynamics will not be avoided the next time there are rumors of default in OTC derivatives markets.
Third, netting arrangements are another risk mitigation technique that can help reduce gross creditor and debtor counterparty positions to a single bilateral credit or debit with each counterparty. The uncertainty about the legality and regulatory treatment of these arrangements can give rise to situations of heightened credit risk. Further and stronger efforts should be made to strengthen the legal basis for netting.
Coordinated Improvements in Disclosure
Coordination is particularly necessary in the area of information disclosure. In finance, information is a source of economic rents. There are natural limits to how much of it will be voluntarily provided publicly, or even privately to establish counterparty relationships. Therefore, the private sector is unlikely, on its own accord, to provide the right amount and kind of information to counterparties, the markets, and authorities, unless it has incentives to do so. Accounting standards and prudential rules require certain forms of disclosure. However, there was insufficient information in 1998 for private counterparts, supervisors, or those responsible for market surveillance to reach the judgment that vulnerabilities were growing in the global financial system. The public sector has a strong role to play in providing incentives for greater disclosure to the markets and greater information on a confidential basis to the official sector.
While, in principle, creditors have incentives to demand adequate disclosure from their counterparties, these can be undermined by competitive pressures and concerns by their counterparties that confidentiality might not he protected. To overcome this, emphasis can be placed on strengthening the primacy of credit risk management, including the autonomy of risk management within organizations to make confidentiality credible, in line with proposals by both private and official groups. The public sector role could be limited to assessing and monitoring the quality of risk management and control systems more systematically and thoroughly, including how information is utilized, and also to ensuring that counterparty disclosure is adequate. The counterparty market discipline imposed by creditors could also be strengthened significantly through better pricing and control of the terms of access to credit.
The challenges in improving public disclosure are formidable. The shift in the boundary between private and public information could, by reducing the private information advantage, lessen intermediation activity. The potential consequences for market functioning need to be weighed against the benefits for market participants from more information on risk concentrations. In addition, it will be difficult to guarantee confidentiality, and even more difficult to develop a consensus on what can usefully be disclosed, in what form, to whom, and how often. For these reasons, an eclectic, innovative approach is needed to address these challenges and pitfalls. Supervisors might promote and facilitate more exchange-like OTC market structures, such as clearinghouses and electronic trading and settlement systems, which would support greater transparency and potentially serve as a nexus for information. Supervisors and regulators could facilitate the adoption of such facilities by regulating them lightly and by devising arrangements for multilateral clearing of contracts that are already covered under bilateral master agreements. Addressing this challenge requires close cooperation between public and private sectors to strike the right balance between financial market efficiency and stability.
Private and Public Roles in Reducing Systemic Risk
In the area of systemic risk, it is important that both the private and public sectors work to reduce it. Private market participants can—by developing and implementing effective risk management and control systems and risk-mitigation tools—individually ensure their own viability and soundness even in extreme circumstances. As noted in International Monetary Fund (1999), well-managed and highly capitalized financial institutions are important components of the first lines of defense against systemic financial problems. Improved risk management and control would reduce the potential for excessive risk taking and the buildup of vulnerabilities at individual institutions, and highly capitalized institutions are better able to absorb losses when they occur. If all institutions succeeded in accomplishing these objectives, the effectiveness of the first line of defense against systemic risk—market discipline—would be strengthened. Under the presumption that a chain is only as strong as its weakest link, unless all of the systemically important financial institutions substantially improve their risk management systems, no financial institution can he assured of dealing in OTC derivatives markets with counterparties that are managing their risks well. Thus, there is some—albeit not a strong—incentive for collective private action centered around improving risk management and the financial infrastructure of these systemically important markets. Such collective private action would support the efforts of industry groups such as ISDA, the Group of 30, and more recently the Corrigan and Thieke Group.108 These efforts should be intensified and accelerated.
In addition to private actions to reduce systemic risk, authorities are responsible for ensuring financial stability, including through prudential regulations, banking supervision, and market surveillance. Regarding prudential regulations, one strong step forward would be for the Basel Committee on Banking Supervision to reconsider capital requirements for off-balance-sheet credit risks. While the Committee’s recent proposals go some way toward more effectively recognizing the risks in off-balance-sheet activities, the increasing sophistication of banks in arbitraging capital requirements and the dynamic nature of OTC derivatives exposures is likely to widen existing gaps in the measurement of banks’ overall credit exposures, and consequently in setting appropriate capital levels. The Committee should give consideration to ways in which capital charges on OTC derivatives positions could more closely reflect the significant changes (positive and negative) that occur in a bank’s current and potential future credit exposures when market prices change. In this context, hanks’ internal credit risk systems could be required to quantify off-balance-sheet credit exposures (both current and potential) as a basis for appropriate capital charges—subject to verification through effective supervision.
More generally, authorities face the difficult challenge of helping to ensure financial stability without encouraging risk taking beyond some reasonable prudent level, without impeding financial innovations, and without unduly distorting market incentives. In principle, safeguards (including parts of the financial safety net) promote a more desirable equilibrium than would be obtained without them. But the safeguards may also encourage excessive risk taking. The challenge of keeping moral hazard to a bare minimum in the first instance requires the authorities to engage in sufficient monitoring to ensure that the insured institutions and markets take appropriate account of the risks entailed in their activities. This means that banking supervision and market surveillance need to keep abreast of the changing financial landscape and the institutions that change it, and also need to invest in developing analytical frameworks for understanding them.