80/20 derivatives

In the FT, Aline van Duyn comments on the Geithner derivatives reforms:

In Mr Geithner’s vision, banks, investors and companies that use derivatives will have to register their activity. In this way, regulators will be able to see the whole picture of risk that has been built up in the financial system. These players in derivatives will all have to put some money aside in case their bets go sour. The amount of bets will therefore be limited. Large parts of the markets will be cleared centrally, which means that the default of a big bank at the centre of the market will not set off a daisy chain of defaults. Regulators will finally have specific jurisdiction over these financial instruments...

First, what is a “standardised” derivative? Is the cut-off size or simplicity?

That is relatively easy. Most banks' derivatives book - and certainly all the big players' books - are mostly vanilla. If you called 'standardised' a plain vanilla interest rate or cross currency swap, forwards, FRAs, caps and floors, plain vanilla swaptions into plain vanilla swaps, and plain vanilla options on single FX rates, equities, equity indices and commodities, (plus the already-DTCC cleared credit derivatives) you would have not just 80% of the industry, but probably more like 90%. Just centralising the clearing of these simple instruments would dramatically reduce counterparty risk and improve market transparency. If you added in basket options, asians and barriers, you would certainly have more than 95% of the industry.

Second, will plans to shift to centralised clearing include derivatives contracts that already exist, or just new ones? This is a vital issue: the risk in the financial system is largely the result of existing contracts. And, as the people still employed at AIG are realising, you cannot just throw these contracts into the river.

There is no reason not to novate old contracts into the new system. It will take time, but you can do it, especially for the inter-dealer business.

Third, who is subject to the regulations? Banks, certainly; large hedge funds, probably. What about smaller investors or companies such as airlines that use derivatives to hedge oil and currency positions?

Regulated banks and hedge funds, plus anyone else with more than a 1% market share, say, in a given market, or anyone the market regulator tells to use the system. The advantages to the banks of central clearing would be large enough that they will pressure big clients to move onto the system anyway.

Aline raises some reasonable objections, but in this case I do think that you can remove 80% of the risk for 20% of the effort.