Moral hazard 101 November 9, 2012 at 8:48 am
Some people seem not to understand why it is a bad idea for a regulator to want to reduce the size of a market. It’s simple: there is enormous moral hazard in that.
Suppose politicians say something is illegal, and legislate. Then you can’t do it any more. That’s clear, but it is NOT what has happened with EMIR. EMIR, remember, is the European Market Infrastructure Regulation (well, it has a longer title now but that is what gave it the name) – it is about how you must trade, and in particular when you must clear some trades (and report them to trade repositories etc.) EMIR, in other words, does not tell you what you can and can’t do, just how you must behave once you have done it. It does not give a regulator the right to aim to reduce the size of a market: it gives them the tools to supervise its activity. Those two things are very different.
It is important to understand that there is a boundary to what society permits supervisors to do. They can and should enact rules to correct negative externalities within the agreed legal framework. They should not become bank managers, dictating strategy, because that makes them responsible for everything that banks do. If you say `a market needs to trade this way, with these safeguards’, then you are regulating; if you say `this market should be bigger and we will make it so’, then you are responsible for the economic and social effects of that market. That is not something that any supervisor should want, and not something society has empowered them to take: we leave that to politicians.
Note that there is a clear regulatory arbitrage in turning a swap into a future. I don’t mean trading exchange traded interest rate futures instead of swaps, I mean producing a bilateral OTC future with the same value as a swap. By simply writing future rather than swap, you reduce capital requirements (1 rather than 5 day MPOR). If your policy aim is to create more futures and fewer swaps, then success might be just a rebranding. That is not effective regulation – it is an unintended consequence of regulatory over-reach. It is exactly the kind of thing that happens when supervisors try to become CEOs instead of rule writers.