Is This the Next Financial Disaster?

by Dave Forest
October 4, 2010

I wrote last week about big changes coming to financial regulation in Europe.

Look for the sequel soon in the U.S. America is buckling down for a new era of financial rulemaking.

Case in point: on Friday, the newly-created Financial Stability Oversight Council met for the first time ever. This 11-person committee is made up of officials from the Department of Treasury, Federal Deposit Insurance Corp, the Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission (amongst others). Its mission is "identifying risks and responding to emerging threats to financial stability."

The Oversight Council is going to be the "front line" in creating harder rules for the American financial system. The stated goal being to prevent another financial crash like the one in late 2008.

And the group is wasting no time getting started. One of items discussed at Friday's meeting was increased oversight of non-bank financial firms.

There's been a lot of criticism since the financial crisis over non-bank entities. The charge being that large financial conglomerates like AIG were allowed to carry out bank-like activities without being subject to the regulation that governs American banks.

The Oversight Council will change that. The group is already off and running creating a list of non-bank entities that should be supervised by the government, and drafting rules on how these institutions should be allowed to do business.

This is going to be a big change for the American banking community. And it's not the only big financial reform coming down the pipe.

Another sore point in the wake of the financial crisis has been derivatives. Simply, financial instruments whose value derives from the value of a separate financial instrument. Derivatives range from the relatively simple (options) to the complex (credit default swaps).

Critics say that over the last several years financial industry players have been allowed to write derivatives too freely. The result being this area of finance ballooned. To the point that the estimated total value of derivates outstanding globally is a staggering $615 trillion.

Another beef is the way derivatives are traded. Often on the over-the-counter market, making price discovery very difficult. Meaning that holders of derivatives have a tough time determining the value of the instruments they carry on their books.

Financial regulators are looking to change this. By requiring most derivatives to be traded through central clearing houses, the way most stocks are. This would create a nexus point for derivatives trade, where information on prices could be gathered and communicated to the market.

This is in process. On Friday, CME Group (owners of NYMEX, CBOT and several other of the major U.S. exchanges) said it is reviewing a proposal from the Commodity Futures Trading Commission on new rules for clearing of derivatives.

This is going to be a major shake-up. Any time you make ripples in a pond worth $615 trillion, there's potential for unintended consequences.

One potential issue with greater price discovery for derivatives is that the discovered price may not be good. Firms that are carrying derivatives on their books at $100 may find out these instruments are only worth $50 in a market context. Leading to a wave of write-downs and subsequent financial problems. Much like we saw after new accounting rules were introduced in the U.S. in 2007.

The new derivatives system won't be here tomorrow, but it's not far off. And when it comes it could have big effects. FYI.

Here's to discovering the real value of things,

Dave Forest