Manmohan Singh's article in the FT about taxing derivatives liabilities: It is an "ouch" moment.

An article in today’s FT by respected IMF Economist Manmohan Singh entitled “It’s time to levy the risk takers” was a classic “ouch” moment. Singh wants to tax derivatives liabilities. It’s a bit confusing.

Singh writes “…Financial statements show that each of the large banks active in the OTC derivatives market in recent years carries an average of $100bn of derivative-related tail risk; that is, the potential cost to the financial system from its collapse after all possible allowable “netting” has been done within the bank’s derivatives book and after subtracting any collateral posted on the contracts. Past research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5tn in under-collateralised derivatives liabilities, a cost taxpayers may have to bear unless some solution to the “too-big-to-fail” question can be profferred…” Singh’s solution is to tax the derivative liabilities, on the bank and CCP level, presumably to act as an incentive to remove the risk and/or at least have a chunk of money available to bail the banks and CCPs out if and when they need it.

So does he mean that a tax should be placed on the potential cost of derivatives under a doomsday scenario? Even the simplest most vanilla derivatives contracts have tail risk. What standard deviation would Singh have banks and CCPs use to determine how much tail risk needs to be taxed? And in that scenario, should they really count the collateral they have? After all, in the worst-case situation, everything is correlated.

The $1.5 trillion of under-collateralized derivatives liabilities that Singh writes about is a nice nugget to waive around. But the point of placing OTC derivatives into CCPs – who supposedly collect safe, liquid collateral to protect themselves – is to eliminate that under-collateralization. Maybe the idea is to simply have the banks stop writing any derivatives business that can’t be cleared? But Singh also takes aim at the CCPs criticizing them as “concentrated risk nodes in the financial system. This may work in in normal times. But what happens in the next crisis.” If the point of taxing derivatives liabilities is to incent the banks to move trades into a cleared platform (e.g. the CCPs), but the CCPs are accidents waiting to happen, what exactly are the choices then?

And what about that under-collateralization? The 2012 ISDA Margin Survey says, “…The largest reporting firms, representing the world’s largest derivatives dealers, reported higher rates of collateralization….Overall, 84 percent of all OTC derivatives transaction executed by the large derivatives dealers were subject to collateral agreements…” Now one might wonder why all of the ISDA-governed trades aren’t subject to collateral agreements? By not asking for collateral banks, for better or worse, have opted to extend credit to their clients. Sometimes those clients are really good risks and the banks are ok with the exposure. A lot of sovereigns fall fell into that basket. Other times the underlying transaction is governed by an ISDA but has tightly limited risk – for example FX spot transactions – and the banks (and their clients) don’t see a need for collateral. A more telling statistic is for credit derivatives where for “…largest reporting firms…an average 96 percent of credit derivatives trades were subject to collateral arrangements during 2011.”

It’s a little late to go back to the 1950s.

We would like to link to the FT article, but it is behind the pay wall.

A link to all the ISDA Margin Surveys can be found here.


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