A Treasury colleague of Steel’s, David Nason, now a managing director of Washington’s Promontory Financial Group, joins him in believing that the challenge awaiting a systemic regulator will be extraordinary. But Nason says there is no question where this regulatory eye in the sky will fasten its attention: on all the interconnections between institutions. And here, he says, derivatives—“highly complicated, specialized, using their own language”—are ground zero.
That means there must be new regulations for OTC derivatives. Naturally the dealer community will resist, since it believes that operating out of direct sight—in the Dark Market, as Born called it—is best for profits. But since the dealers judge some degree of regulation inevitable, their strategy is to hold it to a minimum.
That leaves them not raising Cain about today’s conventional wisdom, which is that “standardized” contracts—for example, five-year, $10 million CDS on a well-known company—must be moved into a clearinghouse. This organization would, first, set capital and margin requirements for its members. Second, it would become the creditworthy counterparty for both the buyer and the seller in every contract submitted for clearing.
But clearinghouses have their own drawbacks. Were there a financial megashock, for instance, some clearinghouse members could be weakened to the point of defaulting on their contracts with the clearinghouse, whose reverses would in turn threaten the stability of other members. Former regulator Corrigan is one expert respecting this risk: He says that if a clearinghouse is to be a financial Gibraltar, it needs sufficient resources to withstand a simultaneous default by two of its biggest members! That would equate to, say, J.P. Morgan Chase and Bank of America going bust. The mind reels at the thought.