Why We Need to Reform Derivatives Trading
Robert Engle is a Nobel Prize-winning economist. After completing his Ph.D., Engle was a professor of economics at the Massachusetts Institute of Technology from 1969 to 1977. He joined the faculty of the University of California, San Diego (UCSD) in 1975, where he retired from in 2003. He now is a Professor Emeritus and Research Professor at UCSD. He currently teaches at New York University, Stern School of Business where he is the Michael Armellino professor in Management of Financial Services. Engle is also the co-founder of the Society for Financial Econometrics (SoFiE). He won the Nobel Memorial Prize in Economic Sciences in 2003.
Question: How will financial regulatory reform help financial markets?
Robert Engle: Well there’s several features. I mean, it’s a pretty complicated set of topics that have been legislated. I like to focus on systemic risk, I think that there’s going to be a systemic risk regulator, which will probably be the Fed, and will chose in committee, select a subset of all the financial institutions that they can consider to be systemically risky and subject them, first of all to more scrutiny, but second of all, to more careful behavior. In other words, restrict their capital requirements so they can’t take on quite a much risk, or maybe put on a systemic risk tax, which is kind of gives them the incentive to become less systemically risky. So, that’s I think, an important part of the legislation. I really like the emphasis on trying to reduce the inner connections of firms through the over-the-counter derivatives market. The fact that this vast array of derivatives are traded over-the-counter means that they’re counter party risks between all sorts of pairs of individuals that are not adequately margined or controlled so that any one company goes bankrupt, it affects a wide range of other companies.
So these also contribute to systemic risk, and what the legislation is proposing is that as many of these over-the-counter derivatives as possible be moved to some kind of centralized clearing so that there is no more counter party risk and improved transparency in this markets, and I think that actually is going to be a very substantial reduction in systemic risk for the system as a whole.
There’s resolution authority saying these companies that are too big to fail just need new kinds of bankruptcy-type provisions. And then we can actually unwind them quickly and without doing so much damage to the entire economy. A lot of ambitious code has been written into the law for those and we will have to see if it actually works, if we have another example of a big financial institution going bankrupt.
I think global coordination is tremendously important. I hope we can see this happening through the G20 and through coordination of regulatory regimes around the world. I guess those are the main features of this bill that are important.
Question: What advice would you give to Barney Frank and other legislators?
Robert Engle: Well, I would say, first of all, congratulations. Because Barney Frank could have been wiped out by the Freddie and Fannie problems, but really, he was instrumental on, but in fact, he rose to a new level, I think, in recognizing what needed to be done to fix the financial system. And I think his bill was really very good. It has a few things I don’t like in it. It has a few exemptions for companies that don’t want to trade their derivatives on exchanges, but I think basically, it was very forward thinking of him to get it out so early to make a statement and pretty much the Senate came along with what he did.
Question: What else would you like to see from Congress?
Robert Engle: I’d like to see a little more action on the energy side of things. I’ve been pushing for some kind of a carbon tax for years, and it seems to me we’ve had lots of opportunities to do it. Today, we’re terribly worried about the size of the budget deficit. We’re talking about should we increase taxes? Why not put a tax on carbon emissions. It would raise a lot of money, it would reduce the environmental damages in the future, it would solve so many problems, and it would be a much more constructive thing to do than to think about raising the income tax.
Recorded May 25, 2010
Interviewed by Andrew Dermont
Cutting down on over-the-counter derivatives trading among banks will reduce the likelihood that if one bank goes under so will the rest.
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