The derivatives industry has found itself at the centre of the debate about regulatory reform, an issue that remains at the top of the international agenda. It can have no complaints about this: CDS played a massive part in whipping up the storm that engulfed Lehman Brothers, and would have claimed other high-profile and economically devastating casualties in AIG, Citi and others, but for the costly government interventions. While many argue derivatives did not cause the crisis, it is hard to argue they did not exacerbate it.
The regulatory debate remains highly contentious. The industry accepts the need for greater regulatory oversight. Yet some participants question the workability – and even the desirability – of some of the proposals that have been made regarding the form this regulation will take, for example in clearing of OTC derivatives.
The dangers are of throwing the baby out with the bathwater. Increasing costs for the innocent corporates using such products exclusively to hedge will only shut them out of the market, increasing risk. Similarly, in forcing standardisation from the top down, politicians run the risk of undermining the products’ usefulness, by making it impossible to tailor hedges to fit the specific needs of the user. This will also end up increasing the risk in the system. The road to better regulation is cluttered with the mines of unintended consequences.
Yet the dangers of inaction are equally grave. Governments are now overstretched financially. Even the US would struggle to repeat the largesse offered to AIG. Yet the cost of allowing an AIG to fail is almost beyond comprehension. The only affordable solution is to ensure such help is never needed again. And anyway, the public demands a response. The political price of inaction is too dear to be countenanced by any career politician. Justice must be seen to be done.
This seems even more pressing when things seem to be returning to "business as usual" in a number of derivatives classes, including rates and equities. Bankers involved in equity derivatives have admitted they have been stunned by the ferocity of the comeback in their business – although it would be going too far to say it has returned to pre-crisis levels. Of particular concern to regulators must be a returning appetite for complexity. Investors naturally shunning exotic derivatives in favour of products they understood bought the regulators time. But they will feel they need to act before the market is again flooded with products that not only spread risk, but hide it.