Ezra Klein: Explaining FinReg: Derivatives

[BlooInBloo]

There's no math in this, so readers will emerge from this article just as ignorant on that as they were when they went into the article. But it is a good clear explanation of the reforms in the Senate bill, and how they help.

http://voices.washingtonpost.com/ezra-klein/2010/04/explaining_financial_regulatio_1.html

Right now, these trades are made bilaterally. That is to say, I make a deal with you for a price that we both agree on. AIG demonstrates the problem with that strategy: One of us might sign more of these deals than we can actually afford if the bets don't go our way.

The clearinghouse solves that problem. It stands between me and you and manages our bet. So when we make a deal, we'd both have to post up some initial money to the clearinghouse. And we have to update that money every day. The trade is "marked to market," which is to say, it's evaluated based on what would happen if it had to be settled today. Whoever lost ground that day has to post more money to the clearinghouse. And all participants have to give the clearinghouse a bit more money beyond that in order to make doubly sure the clearinghouse can pay the bets back.

This does a couple of things. First, it means we know who has bets with whom. Rather than a web of derivatives, it's a map. Second, it means we know everyone can pay off their bets, and we can see if one firm or another is suddenly taking massive hits every day. There would be no AIG-like situation, where they seemed to be doing fine and then, all of a sudden, seemed about to blow up the financial system. We would've watched the wave build rather than only noticing when it was breaking atop us.

So that's the first, and most important, step. The second piece of the puzzle is exchanges. Stocks are traded on exchanges. So are some derivatives. The upside of an exchange is that it creates pricing transparency. If you and me make a deal and don't tell anyone about it, no one knows the price. That's fine for you and me, of course, but what we saw in the financial sector was that we had trillions in derivatives that we couldn't price. Figuring out a price, in fact, was the whole point of Tim Geithner's Public-Private Investment Partnership program.

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The other major policy proposal is Blanche Lincoln's effort to spin the parts of banks that trade these derivatives off from the rest of the bank (at least if the bank wants access to the Federal Reserve's low rates). So rather than there being a Bank of America that trades credit default swaps and holds your deposits, there would be a Bank of America that held your deposits and a BofA spin-off that traded derivatives. Experts I spoke to were split on this, with some saying it's a smart move to break apart the risky parts of banks from the commercial deposit divisions but more saying that it's unnecessary and likely to create a lot of disruption in a fragile economy.