Regulating Capital: the information challenge

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During the financial crisis regulators discovered the hard way how little they knew about the risky derivatives portfolios built up by large financial institutions. Lehman Brothers, for example, was thought to have been a counterparty to about $5 trillion of credit default swaps. When they turned sour in 2008, it brought the financial system to its knees. In response leaders of the world’s main economies demanded in 2009 that derivatives deals should all be reported to “trade repositories”—vast central databases—to make it easier to identify and then reduce systemic risks.

On February 12th, 2014 European rules came into force requiring the reporting of all derivatives to one of six approved repositories. Similar rules have already been in place in America for about a year. But the effort, although concerted, is not consistent: the American and European reforms differ, making awkward transactions spanning the two jurisdictions. Moreover, even if these data can be reconciled, it is not clear what regulators will do with it.

The American regulations allow the reporting to be taken care of by one party to the trade. Yet Europe requires both parties to report. That means every fund manager or corporate treasurer trading derivatives has had to follow cumbersome rules, not just the banks that peddle most deals.  Getting both sides to report was originally seen as a means to ensure that every entity’s exposure could be rigorously monitored. But the complexities of obliging both parties to report trades, which then have to be reconciled with one another, have led many to question whether the additional burden is really worthwhile. “Dual reporting was required to avoid omissions in the data,” says Stewart Macbeth of the Depository Trust & Clearing Corporation, one of the approved repositories. But it “captures a lot of companies in the real economy that probably do not pose a systemic risk”.

The European rules differ from the American ones in other ways too. America staggered implementation of its rules over the course of several months as different sorts of contracts and counterparties were gradually brought within their scope. European regulators chose instead to have everyone start reporting everything on a single day. That created a bottleneck as participants rushed to put the necessary procedures and agreements in place.

Now that the deadline has passed, responsibility shifts to regulators, whose duty it will be to make sense of the torrents of data that are now flooding in. In America the Commodity Futures Trading Commission has openly acknowledged the problems it has already encountered coping with the deluge, with one commissioner blaming “inconsistencies and errors” in the rules. In Europe the problems are likely to be even worse as so many more counterparties are reporting data to multiple repositories. That will create an unfortunate opportunity for both omissions and duplications of data. In time the new reporting rules should reduce risks, but much work still needs to be done.

A paper published on February 4th by the Financial Stability Board (FSB) offers a solution. It proposes aggregating data from multiple repositories into one central one. That may iron out inconsistencies in the data—but it will not necessarily make it any more digestible.

Derivatives:  Data dump, Economist, Feb. 22, 2013, at 65

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