According to a Financial Times article, a European commission examining the credit derivatives industry is asking CDS traders to reduce risk. Ah, if it was only that easy. Kind of like asking someone running a garage sale in the 1980s to sell their old eight-track player for what they paid for it. For one, you are not going to get your original value back, and two, very few people are interested in buying something that may be worthless tomorrow. It is also kind of ironic how we need to reduce risk on the very item we were using to reduce risk in the first place. At some point you cannot just keep passing risk along. Someone has to bear it - which is unfortunately where the government steps in when such exposure is contagious. Fortunately, besides asking for the obvious (and possibly impossible), the commission is forcing its hand a little, stressing how they want a clearinghouse for credit derivatives - otherwise legislation could be introduced. If that is not enough to put the fear in the industry, I am not sure what else is.

The drumbeat continues for adopting some type of central clearing house for the complex derivative products that are current causing issues in the marketplace (see Financial Times article). Such a move has been discussed for some time now (see posts here and here), but recent failures are certainly expected to cause the interest in creating such a clearing house to increase. Unfortunately, such an implementation, which I would support, would not be perfect, nor would it cover every existing type of over-the-counter product. Not everything can be perfectly standardized to allow for an efficient clearing. OTC trading will still be necessary for those specialized products that are offered to not only create investment banking fees, but also hedge a specific risk that a company is worried about. The ability to create these products is necessary to encourage both financial innovation, and reasonable risk taking.

So how would you guard against unreasonable risk taking? The same way as before: regulatory capital. The difference this time is that I suspect that the amount of risk capital that companies will be asked to set aside will have as much to do with both the complexity and liquidity levels as it does with the expected default rates and levels of exposure. Products that cannot be traded on exchanges or through a special clearing house will no doubt be too complex and/or too illiquid to make a market. As such, to better insure that these hard to sell and hard to understand assets are properly covered for counterparty risk, required regulatory capital will increase. If excessively complex, the level of regulatory capital may become so extreme that such "self insurance" could prevent such products from even being developed. Hopefully this will not be the case, or the intent. Responsible financial engineers (I know, that sounds like an oxymoron anymore) need to be able to continue to structure products that will allow for the off-loading of risk on both sides of the transaction. Otherwise, financial innovation and reasonable risk taking will slow down, along with the returns the markets desire. Hopefully regulators will find a "reasonable" balance that will still allow for innovation and risk management. While a flat and less volatile market sounds pretty good right now, eventually risk-taking and an expectation of return will come back to the market. Hopefully future regulation and intervention will allow it.