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Committee on Banking, Housing and Urban Affairs : Statement by Christopher Whalen; United States Senate; June 22, 2009

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Investors in Financial Markets: Big winners. Better pricing, more transparency, less “innovation“ and thus reduced market and liquidity risk, fewer opportunities for severe loss and/or public bailouts.

Taxpayers: Big winners. Less systemic risk, less cost for bailouts of financial institutions, and less time spent by the Congress considering problems that should not exist in the first instance.

Consumers: Big winners. By limiting the complexity of financial instruments, the Congress can act to limit predatory behavior by lenders and major Wall Street dealer firms. If you do not allow overly-complex financial instruments to exist in the first place, then the Congress will effectively limit systemic risk in financial markets.

Dealers: Winners. Less risk, lower returns, makes dealers more stable and less likely to require a public bailout. The illusory, short-term returns for dealers will fall, and with it the supra-normal compensation for traders and executives of the dealers, but the long-term risk-adjusted returns for large dealers will rise and the shareholders of the dealers will benefit.

4) How does the issue of improved OTC derivatives regulation relate to broader regulatory reform issues such as the creation of a new systemic risk regulator, and to what extent do our efforts require international coordination?

“Systemic risk“ is a political concept that does not belong in law or regulation. The perception of “systemic risk,“ which is another way of describing the human emotion of fear, is a function of inefficient markets and opaque, illiquid financial instruments such as CDS and complex structured assets. If the Congress acts to impose regulation on the OTC derivatives markets, then the perceived need for a systemic risk regulator will disappear. The phenomenon of “systemic risk“ is a function of the fear among investors at least partly caused by the supra-normal returns earned by participants in the OTC markets. Once these markets are brought back within the established norms of fairness and transparency, and the nominal rates of return fall to the same levels as those earned in established public markets, then the problem of “systemic risk“ will fade.

The key thing for the public and the Congress to understand is that the „profits“ earned from unregulated derivatives markets are illusory and do not cover the true “systemic“ risk posed by the continued tolerance of OTC derivative markets. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time because OTC markets create risk and opportunities for loss that would not otherwise exist. The net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society.

If the Congress has the courage and the vision to act now to regulate and migrate to an exchange model those OTC markets that have a real, observable basis and ban those OTC instruments that do not have such a foundation, then the need for a systemic risk regulator will disappear and the only need for international coordination will be for the governments of the industrial nations to celebrate the end of one of the darkest, most alarming periods of speculative mania seen in many generations. Thank you.

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