Omgeo's Tony Freeman: Look to Brazil on How to Regulate Derivatives

“If you're not collecting key data on what products exist, it's nearly impossible to properly regulate the market.” Omgeo's Tony Freeman stresses on Benzinga Radio the basic fact that regulators can't regulate what they don't understand, and that's a big part of the problem when it comes to the complex financial products that have grown to dominate the system in developed markets like the U.S. and Europe. It's not impossible, though; Brazil seems to have it (mostly) figured out when it comes to transparency. Freeman:

“Like many other emerging markets, [Brazilian] regulators have very tight control over what happens in their market. The key difference that makes Brazil interesting from an OTC derivatives perspective is that the regulators there are very much better informed about what's going on in their market than regulators are in other locations around the world. Crucially, they know what positions exist in the market, and they know what products are being traded.”

Bolstered by a strict reporting regime and full visibility, Brazilian regulators are working toward ruling out a situation in which phantom counterparty risk brings down whole financial institutions and sends investors running for the exits in a 2008-style meltdown. Thirty years of explosive growth fueled by financial innovation proved simply too much for regulators to stay on top of. Even within the banks, as Freeman points out, risk management could not keep up with the enthusiasm that accompanied these new derivatives:

“If you look at both the US and Europe, what's clear is that there was a huge amount of focus on product development and trading, and there was much less focus by the big banks that dominate the market on the middle office and the back office areas. The rush was to innovate and develop new products and trade them as much as possible. The market grew in size exponentially, but the infrastructure behind the scenes to be able to process and understand the market didn't keep up at the same pace.”

Of course, even given the magnitude of the last financial quake and the fallout that occurred thereafter, it doesn't seem like there is much impetus to sort things out and address some of the ongoing issues these derivatives pose the system. This is no surprise to Freeman, who says that "the complexity of the market was completely underestimated by the regulators who set some timelines." We also asked Freeman about industry pushback and whether that was slowing the process, and the bottom line he put down was pretty clear:

“What's clear is that costs will go up and profitability will go down. But saying that there will be increased costs is not a very productive argument. There are ongoing existing costs of the financial crisis – a vast amount of money was put aside in Europe to prop up failing banks because of their positions in structured products. So the political and regulatory response is that there has already been an enormous cost, and it has been funded by the taxpayer. So, don't come to us and say that this is going to be expensive.” “[Regulation] doesn't necessarily impede growth in the size of the market. One of the interesting features in the Brazilian market is the growth in volume and the number of participants. Having a tight regulatory system and lower levels of opacity than you would see in other markets doesn't seem to have discouraged market participants from investing. The growth rates in terms of volume of transactions are quite astonishing. It is a booming emerging market – obviously the economics are good. But the proposition that more infrastructure, more rules automatically means lower volumes and lower profitability isn't true.”

check out Tony Freeman's piece in the Financial Times: Brazil a possible model for derivatives reform find us on Twitter @matthewboesler, @lukelavanway, @BenzingaRadio, @Benzinga