The Uncertainty Principle---III
by Leo Melamed

International Seminar on Futures Market Regulation
China Securities Regulatory Commission
Beijing, China, August 5, 2010

A recent Wall Street Journal editorial commenting on the U.S. financial reform legislation was entitled, "The Uncertainty Principle". This was followed by another editorial entitled, "The Uncertainty Principle---II". It led me to the idea of adopting the same theme for the presentation at this conference in Beijing. With due deference to the WSJ, I have entitled my remarks, "The Uncertainty Principle---III".

Of course the original Uncertainty Principle was discovered long ago, in 1927, by the physicist, Werner Heisenberg, who won the Nobel Prize for Physics in 1932. In simple terms he postulated that the position and velocity of an object cannot both be measured exactly at the same time. In other words, the act of location of the particle alters the position of the particle in an unpredictable way. While this profound scientific truism is not noticeable for large objects and can be proven only with respect to subatomic particles, it nevertheless is incontrovertibly true.

By no stretch of the imagination could Professor Heisenberg have had in mind the recent US financial reform legislation when he promulgated the Uncertainty rule. Nevertheless, metaphorically speaking, his Uncertainty Principle is descriptive of the Dodd-Frank Act. Any legislative Act that is 2,300 pages long and is estimated to require a minimum of 243 new formal rules to be promulgated by 11 different federal agencies over the next 6 to 18 months is on its face a prime example of an uncertainty principle. Indeed, the WSJ estimated that the regulatory uncertainty created by the bill will last more than a decade.

The number of pages in US financial legislation may not be indicative of anything significant. On the other hand, perhaps it is. Courtesy of Dr. Mark Perry of the University of Michigan, here is a chart of the growth of US financial regulation as measured solely by the number of pages involved:

Federal Reserve Act of 1913-----------------------31 pages
The Glass-Steagall Act of 1933-------------------37 pages
Interstate Banking Efficiency Act of 1994--------61 pages
Sarbanes-Oxley Act of 2002-----------------------66 pages
Gramm-Leach Bliley Act of 1999------------------145 pages
Dodd-Frank Act of 2010----------------------------2,319 pages

It is not my intention, nor would it be possible, to provide a comprehensive analysis of the Dodd-Frank legislation at this conference. The main focus of my remarks will be limited to the effects of the legislation on OTC derivatives and futures markets. Still, I feel compelled at least to offer some general observations about the financial reform legislation which was hailed as a guarantee to prevent future meltdowns. Toward this goal put me in the Skeptic column. Not only is the Act mainly misdirected, to be perfectly blunt---if you substitute the word "definition" for location, and the word "application" for velocity---then just like under the Heisenberg principle, the definition of the Dodd-Frank legislation will be altered upon its application because its meaning and enforcement will materially depend on regulatory interpretation and rules which have yet to be written, and will, I predict, be changed and rewritten over and over again, a process which will take many years. For your convenience, courtesy of Thompson Reuters, I have included a flow chart of the new regulatory structure resulting from the legislation.

CLICK FOR LARGER IMAGE

The underlying rationale of the legislation seems to have been that the primary cause of the financial meltdown was insufficient government regulatory authority. In my opinion, that was not its primary cause. While some new regulatory authority was certainly warranted, there was plenty of government authority on the books that was simply not utilized. Indeed, the government itself was most often the source of the problem. In no particular order, the following are some of the main causes that I included:

Easy money

Unprecedented low interest rates coupled with adjustable rate mortgages

A politically motivated obsession to make home ownership available to low income families, causing a housing bubble

Empowering Fannie Mae and Freddie Mac, two government sponsored entities, (GSEs), to purchase nearly an unlimited amount of sub-prime mortgage debt

Insufficient bank capital relative to assets resulting in an the unconscionable leveraging of the debt-to-assets ratios

Inadequate risk-disclosure requirements relating to the sale of OTC Collateralized Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs)

Failure of rating agencies to properly disclose the inherent risks for these instruments

Poor judgment and lax business practices by Investment Banks and Hedge Funds, allowing risk to become excessively underpriced.

Please note that most of the items in the above list were either government sponsored, had government backing, or were under government control. In my previous analysis, I cautioned that if these fundamental causes were ignored or misconstrued, it will inevitably lead to flawed corrective measures. My fears may have been realized. To quote Economics Nobel Laureate, Gary Becker, "the Bill adds regulations and rules about many activities that had little or nothing to do with the crisis." For instance, the SEC and the Federal Reserve had the authority to increase bank capital requirements and stop abusive lending practices, but did not exercise their authority. Additional discretionary power, as the Bill provides, is just another layer of unnecessary regulatory authority. As Professor Becker points out the most serious omission in the legislation is that it does nothing with respect to Fannie Mae and Freddie Mac who were the most egregious culprits of the collapse. In 2008---supported by the market's assumption that their debt was guaranteed by government---they held over half of all mortgages, and almost all the subprimes. Professor Bob Shiller of Yale agrees, stating that "The housing bubble is the core reason for the collapsing house of cards in the financial market in the US and around the world." Instead, the new legislation creates a consumer financial protection bureau in order to protect consumers from fraud. To our knowledge consumer fraud was not a primary cause-factor of the meltdown. As for the so-called, Volker Rule, which would have gone a long way to protect the public from the costs of a future crisis, the Dodd-Frank Bill adopted only a watered down version. And finally, the Bill gives inordinate discretion to regulatory agencies to interpret the legislation, write the specific rules and then enforce them.

Thus, I am far from convinced that the legislation signed by the President on July 21, 2010 achieves the purposes it set out to accomplish. While some reforms were necessary, the legislation was fueled by the misguided belief that the meltdown was primarily caused by Wall Street. It resulted in a thicket of regulatory enactments that will prove to be a consequential cost burden to the US financial-service sector and an impediment to its overall growth. Much worse, it will deter innovation, the fundamental strength of a modern financial system. By acting alone, the US legislative response may have also created unintended consequences---especially as it relates to other global financial centers---particularly for emerging Asian economies. In the highly competitive international environment such as defines today's global trade and commerce, every unilateral action of one nation has the potential of becoming an advantageous opportunity for another.

Nevertheless, having worked with the members of Congress on the legislation throughout this past year, I must recognize that it represented a Herculean effort. What the Dodd-Frank legislation does accomplish, which we loudly applaud, is to embrace the futures market model as the most reliable construct for the trading and clearing of OTC derivatives. In simple language, the legislation adopts the core tenets exemplified by the CME Group: price transparency, liquid markets with low transaction costs, market integrity, customer protection, and safety and soundness in central counterparty clearing services. These were the reasons that futures markets performed admirably during the financial crisis.

The following represent only the salient provisions in the legislation relating to the operation of clearinghouses and futures exchanges:

Mandated exchange trading and clearing of swaps.

1. The Act mandates trading of clearable swaps on exchanges or swap execution facilities and includes limited exemptions from these requirements for end-users who are hedging narrowly defined commercial risks.

2. These requirements apply across asset classes; however FX swaps can be exempted from these requirements by the Treasury Department.

Comment:

We agree that a central counterparty clearing house, with sound risk management practices, will add a substantial layer of credit protection to participants in the swap market.

We have not been advocates of mandated clearing or mandated exchange trading, however, and instead have supported reasonable incentives that emphasize the value of an independent clearing house.

Clearing house interoperability.

1. The Act prohibits mandated linkages for clearing houses, which we believe will have a positive impact on managing credit risks and reducing broader industry systemic risks.

2. As markets become increasingly interconnected, CME Group believes that central counterparties must carefully manage and not be forced to assume the significant counterparty credit risks of other clearing houses.

Comment:

In other words, the Act prohibits mandated linkages among clearing houses in order to preclude a default at one clearing house from dragging down all the others. This represented a major legislative victory for our markets.

Open access to clearing.

The Act specifies that open access provisions for clearing apply only to swaps, and not to futures or options on futures.

Comment:

We are fully supportive of open access for clearing of swaps regardless of where the transaction was executed (e.g. DCMs, SEFs or the bi-lateral market).

We agree that the wide choice of platforms for executing swaps should permit users to choose the clearing house in which they have the most confidence as an effective and efficient risk manager and in which they are best able to manage their portfolios of derivative positions.

We also agree that the end user, rather than the swap dealer should be the party who has the ability to choose the appropriate clearinghouse.

Mandate to list a swap for clearing.

Designated Clearing Organizations (DCOs) are granted discretion in determining whether to list a swap subject to regulatory oversight.

Comment:

The language grants the CFTC more latitude than we feel may be appropriate to direct a clearing house to clear specific or classes of swap contracts.

We believe DCO should maintain frontline discretion for determining whether to list a swap for clearing.

Position limits.

1. The bill gives the CFTC the authority to set limits for physical commodities (other than excluded commodities) for the spot month contract, each other contract and all contracts combined.

2. The bill tempers the command to set such limits with a statement that the limits should be set, "as appropriate," and a list of factors that should be taken into account when setting limits.

3. The CFTC is directed to establish limits on those swaps that are economically equivalent to those contracts traded on a DCM and these limits must be developed concurrently and established simultaneously with limits placed on a DCM.

4. With regard to Foreign Boards of Trade (FBOTs), the CFTC is also directed to strive to ensure that trading on FBOTs in the same commodity be subject to comparable limits and that any limits to be imposed by the Commission will not cause price discovery in the commodity to shift to trading on the FBOT.

5. The bill also includes a direction to the CFTC to redefine a hedge that may be excluded from position limits.

6. The CFTC is directed to set aggregate limits across related markets.

 Comment:

We believe that exchanges, rather than the CFTC, should set position limits based on their liquidity and open interest.

We also strongly believe that in order for the limits to be effective, they must be imposed equally and simultaneously on OTC markets and similar products traded on FBOTs.

Segregation of funds and bankruptcy treatment of cleared swaps.

Final language permits segregation of swap customer funds, provides bankruptcy protection to collateral of swaps cleared by an FCM through a DCO.

Comment:

We agree that this approach will provide bankruptcy protection and collateral management benefits to our customers.

Swap desk spin-off provision.

1. Banks will be able to retain their divisions that trade "less risky" derivatives, including those based on interest rates, foreign exchange, gold or silver, investment-grade swaps, and hedging for the banks' own risk.

2. However, derivatives based on commodities, energy, other metals, agriculture, and non-investment grade credit-default swaps, will have to be segregated in a separately-capitalized bank affiliate unconnected to the bank federally insured deposits.

Restrictions of bank trading activity (The Volcker Rule).

A modified Volcker Rule passed which will require banks to face stricter limits on trading and investing, but allow them to make small investments in private equity and hedge funds.

Under the new rule, up to 3 percent of a bank's Tier 1 capital could be invested in such funds, and a bank's investment in any one fund could not exceed 3 percent of the fund's total ownership interest.

The rule will also give regulators less leeway in implementing it and require non-bank firms to hold more capital and would bar banks from doing "proprietary trading" for their own accounts when such trading is unrelated to the needs of their customers.

A new interagency Financial Stability Oversight Council, also proposed as part of the overall legislation, would study the Volcker rule and regulators would have nine months after that to implement it.

Clearing house and swap execution facility ownership.

1. This provision requires (rather than permits) the CFTC and SEC to adopt rules to mitigate potential conflicts of interest.

2. The legislation is clear that the methods used to achieve this goal may include numerical limits on the control of, or the voting rights with respect to, these entities.

Capital standards compromise.

This allows a five-year phase-in period for the new requirement for larger financial institutions and exempts those with less than $15 billion in assets from the mandate.

Consumer Financial Protection Bureau.

There will be a single director-led Consumer Financial Protection Bureau housed in the Fed, rather than acting as a freestanding agency.

Hedge fund management registration requirements.

Tougher SEC registration standards will be imposed upon hedge funds investment advisors who manage over $150 million and a provision to ensure that the new registration requirements do not absolve these advisers of existing registration requirements under the CEA.

* * *

In summation, I am very pleased to report that the above provisions pertaining to OTC derivatives and futures markets are quite clear and are favorable to our market arena and specifically to the CME Group. In my opinion the Act will create a continuous flow of new business and opportunities for futures markets. That is of course very good news for our market sector. However, I cannot help but remember that futures markets are but one segment of the overall US financial system. And we are inexorably linked. Thus I fear that the Uncertainty Principle---III, in the words of Professor Alan Meltzer of Carnegie Mellon University, "is the enemy of investment and economic growth."

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