Derivatives reform in America: Swapping bad ideas THE numbers are almost too large to comprehend. The value of one form of derivative traded in America, known as a "swaps contract," in which counterparties agree to exchange cash flows from two financial products, exceeds $400 trillion. The value of forwards and futures, another set of derivatives in which counterparties agree to transact at a date in the future, is about $24 trillion. The value of the American stockmarket is only $23 trillion. Little more than a decade ago Hank Greenberg, then the chief executive of AIG, would respond to questions about his firm's growing derivatives book by scoffing at the notion that size was commensurate with risk. Since AIG's near-collapse in September 2008, prompted by market fears that it had written more credit-default swaps (CDSs), a form of insurance against default, than it could honour, a dramatic reregulation has unfolded. Big firms involved in swaps - not just CDSs, but other instruments, too - had to register by the end of last year. In March rules went into effect on how swaps are cleared. There are now specific requirements for how banks interact with their customers, which swaps need to be cleared, and how data are to be reported. Such rule-making looks sensible on the surface. But where there is regulation there is arbitrage. AIG's ability to build such an explosive CDS portfolio was itself abetted by an exemption in the law for "eligible contract participants" that gave supposedly sophisticated institutions freedom from regulations over swaps. In practical terms, AIG could write lots of business for negligible capital. New regulation of the swaps market will have its own unintended consequences. Some firms will win, others will lose; and the risk is that systemic problems will remain unresolved. The water-bed effect The potential losers in this instance can be guessed at thanks to litigation filed by Bloomberg on April 16th against the Commodity Futures Trading Commission (CFTC), the agency that regulates both swaps and futures. Bloomberg contends that higher margin requirements will disadvantage cleared swaps to the benefit of futures, which can be structured to have the same economic effect with lower collateral and less disclosure. Bloomberg's arguments have a big dose of self-interest. The firm plans to register as a "swap execution facility," a trading platform, the rules for which are still being formulated by the CFTC. Because the structure for the swaps market is in flux, and Bloomberg has a superb electronic network already ensconced in almost every significant financial institution, it is well positioned to be a leading presence in a potentially big new market. The futures market, by contrast, is already dominated by established firms, making it harder for new entrants to grab business. Bloomberg's arguments still ought to give pause for thought. So far, the CFTC's approach has been to focus on the swaps market because it was at the heart of the crisis. In a new paper* Gabriel Rosenberg and Jai Massari of Davis Polk & Wardwell, a law firm, argue that rather than looking at the absolute cost of a transaction in one market, the CFTC would be better off thinking about the relative costs of swaps and futures, both of which it regulates. These relative costs are what will determine the evolution of both markets. The CFTC could then go further, the authors suggest, applying regulation selectively to push one segment of the market (such as farmers hedging grain production) towards one type of instrument, and another segment (banks engaging in complex credit trades, say) towards a different instrument. That makes sense. The scope for regulatory arbitrage shrinks if the choice between a swap and a future depends more on what each is used for. "Regulation Through Substitution as Policy Tool: Swap Futurisation Under Dodd-Frank," April 2013. http://bit.ly/15LzsHa