by Stuart Z. Goldstein
More than 100 representatives from the financial, academic and regulatory communities participated in a forum sponsored by New York University Stern School of Business’ Volatility Institute (NYU Stern) and DTCC that discussed cutting-edge thinking and approaches to achieving the risk mitigation goals under The Dodd-Frank Wall Street Reform and Consumer Protection Act, particularly as it relates to regulation of derivatives.
“Stern faculty have been at the forefront of the dialogue on the financial crisis, examining its causes, proposing solutions that influenced the regulatory response and, now, in assessing the enactment of the most significant financial reforms since the 1930s,” said Peter Henry, Dean of NYU Stern School of Business. “In partnering with DTCC, we have the opportunity to bring together academics, practitioners and policymakers for an important dialogue on how best to implement the new rules of Dodd-Frank, which will shape the future direction of global capital markets.”
The conference was led by three highly regarded industry experts, including Professor Robert Engle, Nobel Laureate and the Michael Armellino Professor of Finance at NYU Stern; Professor Darrell Duffie, the Dean Witter Distinguished Professor of Finance at Stanford University; and Commissioner and Former Acting Chairman Michael Dunn of the U.S. Commodity Futures Trading Commission (CFTC).
Approaching risk 10 by 10 by 10
Stanford’s Professor Duffie challenged the audience to think about managing systemic risk in a dramatically different fashion. “The key – in headline form – is having a systemic risk regulator that is able to monitor the sizes and directions of flows of risk through the center of the financial system. The top 10 systemically important firms would report their gain or loss with each of their top 10 counterparties, for each of 10 key stress scenarios,” he said. “While in practice there may be more than 10 such firms, counterparties or stress scenarios, regulatory monitoring of exposures along these three dimensions is the bedrock of systemic risk management as it captures both a range of systemically important stress scenarios, as well as interconnectedness of exposures,” he added. Professor Duffie suggested that stress scenarios and exposure measures would be refined over time as experience is gained, but initial examples of stress scenarios include:
- the default of a single entity;
- a 4% simultaneous change in all credit yield spreads;
- a 50% change in a global equities index;
- a 50% change in the prices of all energy-related commodities, etc.
He also suggested that initial exposure measures should be computed on both a net and (except where legally enforceable close-out netting agreements are in effect) gross basis and should be determined both before and after the use of collateral. Exposure in terms of potential cash flows should also be monitored. Systemic risks posed by CCPs NYU Stern’s Professor Engle warned conference attendees that some of the new measures under Dodd-Frank, such as requiring the use of central counterparties (CCPs) for over-the-counter (OTC) derivatives transactions, may create new systemic risks while reducing old ones.
“Large one-sided executions by systemically important firms in the OTC derivatives markets were key creators of systemic risk contributing to the crisis of 2008. Under stress, even very large firms with one-sided positions can fail, as demonstrated by AIG. Such failures may lead to further insolvencies, thus creating system-wide distress,” said Professor Engle. “In a world where most OTC derivative trades were not cleared, the natural mitigant of this risk was increasing execution costs as these exposures become better known in the market, but this was always hampered by incomplete information and hence not particularly effective.
“Standardizing OTC derivatives contracts and requiring standardized contracts to be cleared through CCPs will not eliminate this systemic risk, but rather will merely transfer it to the CCPs and, by extension, to those market participants relying on the viability of the CCPs,” he argued. “Further, since the existence of a CCP obviates the need for individual counterparties to charge more for executions that increase large one-sided positions, the central counterparty itself must institute alternative processes and procedures that effectively mitigate the risks created by large, concen-trated positions.”
Professor Engle recommended that these should include concentration and possibly credit-based margins, particularly when the maximum loss is very big relative to natural margins as in credit default swaps. “In any event, regulators, and particularly the Financial Stability Oversight Council, should pay particular attention to these issues as the systemic risks posed by central counterparties will increase with the increased clearing of OTC deriv-atives. Fortunately, these institutions are easily identified and regulated,” he added. ‘A collective challenge’ Participants at the conference, “Managing Counterparty and Systemic Risk under Dodd-Frank,” included regulatory officials from the CFTC, Securities and Exchange Commission, Federal Reserve Board of New York, academics, senior members at top-tier financial firms and key congressional staffers. The conference was held at the Henry Kaufman Management Center at the NYU Stern School of Business in New York City.
“Our shared aim with NYU Stern is to host a timely forum to explore issues that meet at the intersection of public policy, regulatory inter-pretation and market experience,” said Donald F. Donahue, DTCC chairman and CEO, during his welcoming remarks. “The rulemaking process here in the U.S. is moving at warp speed as regulators look to propose, revise and finalize hundreds of new rules that will literally transform market structure in virtually every area of financial services – and to do it all by the July 2011 legislative deadline mandated by Congress.
“I can tell you from my conversations with our regulators that they understand the magnitude of this responsibility – and we recognize the transformative change their actions will have on global markets and the global economy. Our collective challenge, therefore, is to help regulatory agencies write new rules that effectively meet their goals of greater risk mitigation and transparency while still maintaining the compet-itiveness, efficiency, liquidity and robustness that have long characterized the U.S. marketplace.”
NYU Stern School of Business has a long history of sponsoring topical and insightful forums that provoke discussion about key issues shaping the financial marketplace. Recently, 40 Stern professors authored a book, “Regulating Wall Street,” which assesses the strengths and weaknesses of Dodd-Frank. @