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Dewey & LeBoeuf LLP: Holistic Risk Management, Not More Tax, Needed In Derivatives Clearing
Date 30/03/2011
The FT today reports on Manmohan Singh's latest working paper for the IMF on OTC derivatives clearing (("IMF queries derivatives reform effectiveness") and he has again proposed a tax on banks' derivatives payables.
Dewey & LeBoeuf Financial Regulation partner comments:
'Mr Singh's paper is excellent in many respects but his arguments in favour of a tax to incentivise banks to clear their derivatives contracts and to treat central counterparties (CCPs) as public utilities are unconvincing, especially given his achnowledgement "may be to-big-to-fail" institutions in the making.
The systemic risk implications of central counterparties CCPs are already well-recognised by regulators and the financial sector. Daniel Heller at the Bank for International Settlements (BIS) in Basel warned in 2009 about the systemic risk implications of migrating OTC derivatives to CCPs and the contagion risk of linking CCPs. But Federal Reserve Bank chairman Ben Bernanke identified this more than 20 years ago, after the 1987 crash.
The risks demand a holistic approach, whereas politicians have been content to push ahead with regulatory reforms to force central clearing without adequately considering the legal, liquidity and other risks that remain to be addressed. Indeed Heller commented "Forcing all types of derivatives onto CCPs would most likely undermine the very financial stability objective all want to achieve." These risks are all the greater in Europe where bankruptcy and other laws are much less harmonised than in the US, and the proposed European Market Infrastructure Regulation does little to address counter-balance the resulting risks. Thankfully, interoperability for derivatives CCPs now seems to be on the back-burner.
A derivatives tax, as proposed in the IMF working paper is definitely not the answer, especially coming on top of transaction levies and increased capital charges for uncleared derivatives. Rather, the risks inherent in the growth of CCPs need to be managed and the shift to central clearing should progress at a more measured pace. Most CCPs will be systemically important financial institutions, and too-big-to-fail. Yet neither politicians and regulators have inadequate answers to to key systemic issues - such as the risk weighting of banks' CCP credit exposures, the dramatic effect on securities markets of the anticipated huge increase in CCPs' collateral holdings, CCP access to liquidity in times of stress, and the impact of the bankruptcy of foreign clearing members. G20 leaders certainly did not appreciate the implications of their commitment at the September 2009 Pittsburgh Summit to central trading and clearing of OTC derivatives.'