Defusing the $700 Trillion Time Bomb

Wall Street isn't waiting for regulators on derivatives reform.
Author:
Publish date:

NEW YORK (

TheStreet

) -- Fast and ineffective or too slow to matter?

That seems to be the choice facing those of us who would like to see meaningful reform of the $700 trillion market for what are known as "over-the-counter" (OTC) derivatives, instruments that

Berkshire Hathaway

(BRK.A) - Get Report

Chairman

Warren Buffett

famously called "financial weapons of mass destruction."

When times were good, few people seemed to realize that the rules of the road in this opaque market were nothing more than guidelines put forward by the financial industry. When the crisis hit and major players in the market such as

AIG

(AIG) - Get Report

began to topple, those guidelines proved ineffective and markets seized up as financial institutions around the globe demanded their money back all at once. It was the institutional equivalent of a run on the bank--except that the bank was a $700 trillion global market.

Now regulators have new authority to police that market. The Commodity Futures Trading Commission, which had been a regulatory afterthought that made the laissez-faire

Securities and Exchange Commission

look important by comparison, now has new authorities. Chairman Gary Gensler, despite his

Goldman Sachs

(GS) - Get Report

credentials, has earned the respect of some longtime opponents of Wall Street.

At the same time, Gensler has given comfort to financial industry players that he is a moderate, such as when he indicated at conference held Sept. 16 by the International Swaps and Derivatives Association (ISDA), an industry trade group, that he does not believe that derivatives contracts entered into before enactment of the Dodd-Frank Act should be subject to new margin requirements.

Lauren Teigland-Hunt, an attorney who represents financial institutions on derivatives matters and a panelist at the ISDA conference, said she found Gensler's view "encouraging." It is also likely to be encouraging to Buffett, who

lobbied unsuccessfully

to ensure Dodd-Frank would protect existing trades from being subject to new margin requirements. Teigland-Hunt says the new law is unclear on the issue.

What remains to be seen is how successful regulators will be at creating new rules for the massive, complex market. One executive at the ISDA conference who believes the new rules will create a new business opportunity for his company expressed frustration with regulators' slowness.

The executive was in Washington for a

roundtable

earlier in the month, and said regulators questions were "on the most elementary issues," adding "they were asking the same questions three months ago. They need to get moving."

Gensler seemed acutely aware of such criticisms during his speech. Noting that Dodd-Frank requires the CFTC and SEC 360 days to write rules for OTC derivatives, he said, "for those of you keeping track, we have 303 days left." In an apparent effort to stress the alacrity with which regulators were undertaking their tasks, Gensler announced that team leaders from the CFTC and SEC had met "within 24 hours of the President signing the Dodd-Frank Act."

On Tuesday, the CFTC announced it would hold an open meeting Oct. 1 to discuss some initial rules it will propose.

The financial industry, however, may be moving more quickly in rewriting its own guidelines. Speaking before some 200 attorneys from institutions including

Bank of America

(BAC) - Get Report

,

JPMorgan Chase

(BAC) - Get Report

,

D.E. Shaw

and

UBS

(UBS) - Get Report

, Teigland-Hunt described new ISDA guidelines for resolving collateral disputes between parties in derivatives trades.

The new guidelines were born out of disputes between several dealers, including

Goldman Sachs

(GS) - Get Report

and

AIG

(AIG) - Get Report

's financial products division in 2007-8 over how certain credit default swaps trades should be valued for collateral purposes. Though the trades were done in accordance with something called the ISDA Master Agreement,

pricing disputes

between AIG and the dealers went on for months.

"The industry realized we need to have more robust dispute resolution procedures because in a stressed marketplace we don't want disputes to linger for months," Teigland-Hunt says, adding that the industry hopes to have initial revisions to the agreement in place by the end of the year.

The new procedures are pretty complex, and still seem to offer plenty of room for lawyers on both sides to find things to disagree over. Teigland-Hunt acknowledges their complexity creates a strong argument for so-called central clearing of trades, in which such disputes don't come up because there is no ambiguity about collateral posting requirements. The function of clearinghouse is to value the trades and determine how much collateral needs to be posted.

"If you clear, the clearinghouse makes a call. You don't have an opportunity to dispute it," she says.

Indeed, Wall Street succeeded in convincing Congress that some of its instruments cannot be cleared because they are non-standard and difficult to price. Forcing all trades to be cleared, banks have repeatedly argued, would stifle innovation. Given the damage such innovation has done to the economy over the past three years, that might not be such a bad thing. Distressingly, though, central clearing for all derivatives is no longer on the table as an option.

In short, the path for innovation in OTC derivatives markets looks wide open. Strap on your seatbelts.

--

Written by Dan Freed in New York

.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.