In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

As regulators and others look to solve the problems that led to the current credit crisis, or at least look to find something to blame, derivatives are often an easy target. After all, most people don't understand them, let alone know what their benefits are. They simply know that derivatives are complex, risky, and make a fortunate few a lot of money.

A recent Reuters article highlights how regulators are looking to standardization of the over-the-counter derivative market as a potential solution to current problems. But will this help? While it may make future products easier to understand, it is also likely to prevent the type of innovation that is often needed to develop the products necessary for facilitating the transfer to risk to those who are best able to handle such risk. As such products are removed from the system, it is likely that the Government will increasingly be forced to come to the rescue, nationalizing more risk at the taxpayer's expense. As an example, there is no doubt that the credit default swap market needs to be more transparent, but can this be done without standardization, or simply putting everything through the same cookie-cutter framework? While such a system could help eliminate large losses, it may be at the expense of slower growth and innovation. Hopefully regulators will continue to take this into consideration.