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  • A Band-Aid for Derivatives Trading

    Uli Deck/dpa/picture-alliance/Newscom

    Uli Deck/dpa/picture-alliance/Newscom

    American regulators yesterday agreed, both internally and with the European Union, on how to deal with the trading of financial derivatives beyond U.S. shores. The EU and U.S. essentially decided to treat each other’s rules as “close enough.”

    While the decision has some value, it continues to miss the point. No set of regulations can match the speed of innovation in trading. If investment houses continue to believe they will be bailed out, the risk to American taxpayers will remain high. Contributing to that risk is the Federal Reserve’s sustained loose monetary policy.

    The U.S. was under pressure to decide how to extend the problematic Dodd–Frank Act to offshore and overseas trading of financial derivatives. A major factor in trying to get the rules right was matching them to parallel rules crafted by the EU. Companies subject to two sets of regulations would be disadvantaged compared to companies subject to one. Differences in the two could spur large, destabilizing money movements from one jurisdiction to another.

    On Thursday, the EU and U.S. decided that firms trading derivatives across jurisdictions will be allowed to decide on which regulations to choose, and application of regulations to such firms will be delayed until disagreements over margin requirements and other sticky issues are resolved.

    The apparent resolution does reduce rising uncertainty. It also shows that America and Europe can cooperate on contentious financial issues in time for the start of talks on a Trans-Atlantic Partnership.

    However, the new regulatory framework has a shelf-life of about a year. Governments are still trying to work out implementation of Dodd–Frank as a solution to trading problems from 2007. There is no way bureaucrats can keep up with markets: In two years, the new rules will be obsolete.

    That sounds a bit scary, but it doesn’t have to be. The first way to discourage irresponsible trading is for the U.S. to come to a consensus that individual private financials should be allowed to fail. We have a remarkably resilient financial system, and there is no need to panic because high-profile investors don’t want to pay for their mistakes. The idea of equities markets is to trade risk for return. If governments stopped subsidizing on the risk side, they would have to worry far less about dangerous behavior in seeking returns.

    Another genuinely helpful step is to curb the Fed’s seemingly endless quantitative easing. There’s a reason money supply is referred to as “liquidity.” Money is like water: It’s always going to flow somewhere. If there’s too much money flowing, prices of some assets will rise—houses, gasoline, stocks, derivatives, etc. And if credit is loose for too long, no regulation can keep markets stable.

    Yesterday’s agreement isn’t a terrible outcome. But it leaves the U.S. still walking down the wrong path in promoting a strong financial system.

    Posted in Economics [slideshow_deploy]

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