Pulling Back the Derivatives Curtain

The lack of transparency in financial markets was a significant contributor to the 2008 financial crisis. The risks of toxic securities were hidden behind layers of complexity, and the credit rating agencies tasked with making the bottom line transparent to buyers had crippling conflicts of interests.

On the institutional level, the tangled balance sheets of the critical dealer banks were a major contributor to the market freeze that occurred in late 2008. Uncertainties regarding opaque over-the-counter derivatives, complex interbank relationships and “toxic asset” exposures were such that counterparties simply refused to deal with major banks at the center of the system, and the markets froze. Regulators also clearly lacked understanding of bank risk exposures both during the crisis and in the years leading up to the crisis when intervention could have been effective

At the heart of the transparency problem was and is the complexity of the shadow banking system, in which credit is intermediated through extensive securities market relationships. The balance sheets of traditional banks could be understood by examining the underwriting of their loans and their relatively limited set of funding sources. But modern universal banks have a tangled web of securities exposures involving enormously complicated derivatives commitments, short-term funding collateral and elaborately structured securities.

The shadow banking problem is far from solved. But recent financial reforms contain numerous elements that could improve the availability of critical data. However, it’s still far from clear that all of these initiatives will be properly implemented.

What’s more, the ability to integrate and interpret this flood of new data is still lacking. It’s an open question whether all this raw data will result real knowledge that will help both regulators, market participants and the public understand the financial system more effectively.

Here are some of these initiatives:

Derivatives market transparency: For market participants, trading facilities will now offer real-time data feeds for the trading of standardized swaps. Transparency to market participants is still lacking for so-called over-the-counter swaps. For regulators, new swaps data repositories should massively increase the information available to regulators on all swaps.

Transparency of banks: The newly approved international Basel rules contain a list of new bank disclosures that are meant to update the traditional “call report” and 10-K to give more information on the activity of dealer banks. Depending on implementation, these disclosures have  the potential to significantly improve information available to market participants. New accounting rules should also reduce the ability of banks to conceal assets off balance sheet.

On the regulatory side, banks are now required to submit “living wills” to regulators detailing how they could be resolved in the event of financial difficulties. These should greatly improve regulators understanding of bank internal structure. However, their current public versions offer little to no transparency to market participants.

New tracking of credit exposures will also improve regulators’ understanding of interrelationships in the banking system, and regulators at the New York Federal Reserve are working to improve information on securities lending markets. Regulatory stress tests have also improved the effective transparency of bank activities to regulators, as these stress tests require tracing out relationships that may not be visible on the balance sheet alone.

Securities market transparency: The Securities and Exchange Commission has issued new rules on disclosure requirements for asset-backed securities. New SEC rules for credit rating agencies are designed to improve the reliability of ratings information and thus the transparency of securities, although the SEC has apparently rejected radical reform and the effectiveness of its proposed rules seems highly doubtful.

In addition, the new common securitization platform being designed by the federal housing agencies could radically increase the availability of loan-level data for mortgage-backed securities, and possibly simplify and standardize the structure of asset-backed securities as well. One of the few areas of consensus in the reform debate is the desirability of improving the standardization of mortgage-backed securities to make them more transparent for investors.

Overall financial system transparency: The new Office of Financial Research has the ability to amass information centrally to map out areas of stress in the financial system, and also has various legal powers to improve information standardization and accessibility in the markets.

But despite the impressive number of initiatives in progress, it is doubtful that the financial markets are much more transparent to even sophisticated users than they were five years ago. Only a small amount of the new data is available to the public as opposed to regulators. And even regulators, with full access, have great difficulty making sense of the data.

The experience of the so-called “London Whale” demonstrates the continuing limits of regulators’ ability to truly understand bank operations. Richard Berner, the director of the Office of Financial Research, recently admitted that regulators were far from a clear understanding of the nature and location of systemic risks. Data gaps continue to exist, and lack of standardization even in the data that is available makes it hard to use analytically.

Much more work must be done to turn data into real understanding. Besides problems with the data itself, too little is available to the public, even in aggregated form. Along with particular initiatives, regulators need to think about how to engage market analysts, academics, and the public in “crowdsourcing” a better interpretation of the financial system.

— Marcus Stanley

Originally published on USNews.com.