Gensler on CDS and Regulation

Its refreshing to know that at least there is some intelligent people out there.
I have had my issues with CTFC head Gary Gensler, but he is right on the money with this piece about CDS and derivatives regulation. We have far to many people who just don't know much about them writing for major publications who are spreading half truths and outright lies about derivatives.

http://blogs.wsj.com/marketbeat/2010/03/09/cftc-chair-gary-gensler-address-to-markit-otc-derivatives-markets-conference/tab/print/

The truth of the matter is regulating just CDS is not going to cut it. The entire OTC derivatives market needs to be regulated better. This goes back to my point that dealers need to be properly capitalized. It's not a question about putting them on exchanges or making them more standardized. Its all about the counter party risk. The only way to fix this is to make banks/dealers accountable to their reserve levels. The only reason the banks held rotten toxic loans off balance sheet was because they would not have to account for them in the normal way. The banks created SIVS/OBS/SPF for the simple reason that these vehicles allowed them to load up on leverage without damaging their own balance sheets.

Once we get the dealers up to snuff on their capital levels we can look to gradually put these derivatives on exchanges. Once this happens, the liquidity will dry up because traders do not like transparency. I know this for a fact because I used to trade these derivatives personally. I loved the fact that they were complex and not many people knew about them. What you don't know can only help me.

The hope is that other market participants then can come in and take up the slack. This is similar to what happened on the NASDAQ markets after the Manning Rule was put in. Now all of the stocks traded on NASDAQ were already on an exchange, but many orders were simply not shown. This was a clear case of non-transparency that needed to be cleaned up. There needs to be more transparency in the OTC derivatives space. There is enough money to go around because there is so much debt outstanding that needs to be hedged. The big banks just don't want to share the pie. Once we get more participants, the bid/ask levels on CDS will be more indicative of the real credit risk that is out there. Spreads will naturally compress. This will lower the cost of execution and make the market more liquid and more competitive longer term. You don't need to ban CDS or get rid of naked CDS. This is absurd and its not realistic. The CDS market is holding/propping up trillions in synthetic CDO's at the moment. Housing currently is in a precarious situation. It's most probably going to take another vicious hit in the coming months. We don't need a total collapse in the S-CDO market to coincide with it.

The idea of a clearinghouse is also a decent proposal. But it doesn't take away the inherent risky nature of derivatives. Don't hand out blow torches to the arsonists. Make dealers/banks accountable with regards to their abilities to repay claims. What good is a clearinghouse when one party cant settle or pay out? The clearinghouse is then on the hook for the losses. Clearinghouses do a good job of reducing risk but that only comes from a more robust competitive trading environment.

Now...Lets get something straight.

Speculators are vultures. But they don't always cause a market crisis. In fact, speculators rarely cause crisis. Crisis usually start when investors overindulge, over leverage, and over stay their welcome in a given asset class. Speculators like vultures, swoop down to attack weak players. Lehman, Bear, AIG, Wamu, and a host of others were done in by reckless traders and careless risk managers who kept their foot on the peddles when they should have stepped on the brakes. Is it the speculators fault that these companies were trading so high relative to their fundamentals?

There are clearly things wrong with the CDS/Swaps market. Structural changes need to be made. We can fix them without banning them. Banning them only legitimizes the Joseph Casano's & Dick Fuld's of the world. It gives those people who ran their companies into the ground a reason to say it wasn't their fault.