On this basis, they conclude that a two-year delay in clearing for such entities "should not compromise the primary objective of the clearing obligation, which is the reduction of systemic risk." While ESMA likely does not have authority to effect more than the delay they have called for, their data makes a compelling case for even more consequential action—namely, removing clearing burdens from smaller market participants altogether.

It became clear that there was systemic risk in the OTC derivatives market when AIG's near-failure precipitated a $180 billion taxpayer bailout. Approximately 20 percent of bailout funds were used to settle AIG's derivative-based bets on the subprime mortgage market. Lehman Brothers' failure also revealed shortcomings in the market, especially that limited information on its exposures forced market participants to assume the worst, contributing to a crisis of confidence.

After stopping the economic freefall, governments globally sought to stitch lessons learned into the structure of derivatives markets. At the vanguard of a multifaceted strategy to attack risk was central clearing, a mechanism already used in the futures market that centralizes credit risk, backstops it with cash and securities, and systematizes its management. Parallel efforts to increase transparency in a market widely regarded as opaque were centered on swap data reporting, a means of arming regulators with better information to probe for systemic risk. In the absence of good data on systemic risk, policy-makers chose to broadly apply these corrective mechanisms without evidence on the consequences to smaller firms.

Now that the derivatives market protections are nearly complete, policy-makers can use one crisis-era solution to assess another. Specifically, regulators can apply data in their repositories to assess whether central clearing and other risk-reducing protections (e.g., margin) are necessary for smaller firms. Such an assessment is necessitated because central clearing rules were applied not only to the likes of AIG and Lehman, but also to any entity whose activities might be considered financial, including management consulting firms, real estate funds, credit card processors, and microfinance funds. When derivatives laws were passed, regulators did not have data on the degree to which smaller entities contributed to systemic risk, or on the costs of bringing such entities into the clearing regime. The recent ISDA and ESMA releases offer the first hints of the ways in which this data could be used to ensure crisis-era solutions do not unnecessarily harm smaller firms.

Applying systemic risk protections to smaller firms has subtle but far-reaching effects on consumers and the wider world, including added difficulty accumulating retirement savings, higher fees on credit cards, and even difficulty reaching the world's poor with poverty alleviation tools such as microfinance.

Accepting these outcomes as the collateral damage of a crisis-avoidance imperative would nullify an incredible possibility—the opportunity to precisely achieve the ambitious goals of reform, to focus systemic risk protections only where systemic risk exists. Realizing such an opportunity in the derivatives market is straightforward; it's achievable through a data-driven initiative to remove burdens from those that transact in small quantities—a "financial entities de minimis exception."

Far from weakening reforms, a data-driven approach to right-sizing regulations for smaller players would be a logical extension of one of derivatives reforms' great achievements: bringing the once-opaque derivatives market into the light.

———————————–

Luke Zubrod is a director at global risk management advisory and technology firm Chatham Financial and is a member of the CFTC's Market Risk Advisory Committee.