The difficulty of regulating the shadow-banking system

Regulation of the shadow banking system, with its non-exchange traded (over-the-counter, private contracts) and customized derivative instruments, is surely top on the priority list of all financial market reform proposals. But as Alan Blinder writes in a WSJ op-ed, the preferred approach of standardizing derivatives and moving their trading into organized exchanges will run up against formidable obstacles.

"The primary beneficiaries of customization are the ... five big Wall Street firms... If they can stave off standardization and exchange trading, comparison shopping will remain very difficult and profit margins will remain sky high. But if reform makes standardized, exchange-traded products dominant, competition will squeeze profit margins to the bone."

In addition to providing information about prices and volumes, exchange trading would subject derivatives to a full range of regulations, including disclosure and reporting requirements and stricter antifraud rules. And as expected, as a Times op-ed writes, the proposals now under discussion before the US Senate does not appear very promising

"The bill would allow too many trades to be done off the exchanges. Regulators would be able to police them, but there would be no ongoing investor oversight. There are carve-outs for certain corporate users of derivatives and for contracts tailored to unique purposes. The bill also would allow the Treasury secretary to exempt an entire type of derivative known as foreign exchange swaps. Corporate pension funds that invest in derivatives would be subjected to less scrutiny than is required of many other investors. The financing arms of major manufacturers would also escape full scrutiny. All of that is going in the wrong direction."

The Times op-ed advocates going beyond mere regulation of derivatives and proposes an outright ban on abusive derivatives like that sold by Goldman

"The Goldman deal was nothing more than a bet on the mortgage market, in which one side was destined to win and the other to lose, without 'investing' anything in the real economy. The CDO did not hold actual mortgage-related bonds, but rather allowed the participants to stake a position on whether bonds owned by others would perform well, or tank. And that helped to further inflate the housing bubble. That is not investing. It is gambling, and it is abusive. It has no place in banks that can bring down the system if they fail... Congress should ban both gaming and abusive derivatives. That would help clarify the difference between pure speculation and true hedging. It would start to restore what has been lost in the crisis: public confidence in the integrity of financial markets."

In many respects, the final outcome on the regulation of the shadow banking system will be the acid test for the extent of influence wielded by the Wall Street firms on the Washington establishment. No other reform proposal impinges so directly and immediately on the profitability of Wall Street. Unless something dramatic happens, I am inclined to believe that any reform to bring derivatives under the umbrella of the regulatory agencies will be considerably diluted by what it excludes from its ambit.

The Goldman scandal, which involved the use of precisely such customized derivative products (in this case, synthetic CDOs, with underlying CDS's), and the momentum of public outrage generated by it is an excellent opportunity to bell the cat on reforming the shadow-banking system.

Update 1 (13/12/2010)

Excellent NYT article on how the big banks control the derivatives trading processes, preventing the development of independent clearing houses and electronic trading platforms.