I recently re-watched a documentary which was produced in the immediate aftermath of the global financial crisis. Entitled “The Warning”, it tells the story of how Brooksley Born, the one-time head of the US Commodity Futures Trading Commission, was thwarted in her attempts to get US regulators and the Federal Reserve to implement meaningful oversight reforms to the over-the-counter (OTC) derivatives market.
She had been highlighting the systemic threat posed by OTC products a full decade prior to the Lehmans Bros collapse, but her warnings went unheeded by the likes of Federal Reserve Chair Alan Greenspan and Treasury Secretary Robert Rubin.
It wasn’t simply enough to quash her attempts to beef-up the regulatory framework; matters were to become even more laissez-faire on the derivatives front, with the passing into law of the Commodity Futures Modernization Act of 2000.
The introduction of this Clinton-era legislation meant that OTC transactions would not be regulated under the Commodity Exchange Act of 1936 or as "securities" under the federal securities laws. In short, the legislation effectively gave the green light to hedge funds, banks and other financial institutions to use derivatives for speculative trading, not just for standard hedging arrangements. Prior to the Commodity Exchange Act, any derivatives that could not be proven to hedge against a real-world position were legally unenforceable – there was no financial incentive for speculators.
I wonder what Born would make of the recent ructions linked to Archegos Capital Management? Both Credit Suisse Group AG (SWX: CSGN) and Nomura Holdings (TYO: 8604) have incurred heavy losses after the hedge fund was forced into a fire-sale of assets and defaulted on its margin calls. Nomura revealed that the estimated amount of the claim against Archegos is approximately $2bn (£1.47bn) based on market prices as of 26 March, while Credit Suisse cautioned that associated losses “could be highly significant and material to first quarter results”.
The situation differs from 2007 in terms of scale and the potential for systemic risk, but what would interest Born is the hedge fund’s use of swaps to build their positions across the board. There are two main advantages to gaining equities exposure in this manner. Firstly, you can do it on the cheap, as you only require a modest outlay when compared to buying stocks outright. Secondly, these trades and the resultant positions can go under the radar as they’re not included in the SEC’s reporting obligations – an indirect result of the failure to adequately regulate in this space.
Archegos has also exploited a loophole in the Dodd-Frank Act, further enabling it to avoid the kind of disclosure you might think is warranted given the weight of its holdings. It’s all depressingly opaque. Then there's the spectre of excessive leverage, though Wall Street still seems to be more concerned by excessive caution. Born, unlike Greenspan and his acolytes, saw the dangers in a resolutely hands-off approach to the derivatives market, but I doubt whether she is given to schadenfreude, particularly as this latest self-inflicted wound suggests that we have learnt little from the events of 2007.
