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The rise of the Texan sharpshooters?

Published in Automated Trader Magazine Issue 29 Q2 2013

There is a story about a Texan who fires a bunch of shots at the side of a barn. Once he's done shooting, he walks over to the barn, paints a target centred on the biggest cluster of shots, and calls himself a sharpshooter. So what, you may ask, does this have to do with swaps regulation?

The rise of the Texan sharpshooters?

(Editor's note: see related story on SEC's deployment of MIDAS here.)

The story gave rise to what's known as the Texas Sharpshooter Fallacy. It occurs when random data points are analysed until a pattern is found, the significance of which is then assigned after the fact. Are leading derivatives regulators setting themselves up to become Texan sharpshooters?

"I do think that there's a sense of: 'We'll figure out what the data is telling us after we get the data', rather than 'What exactly are we looking for, and therefore what data should we collect?' " Mark Calabria, director of financial regulation studies at the Cato Institute, said.

"Unfortunately, there are probably many things in Dodd-Frank that we're only going to figure out how they work when they're actually put into practice, or when an individual firm gets into trouble or failure. So in terms of providing guidance for the market place, I don't find it to be a very good roadmap if one is structuring one's business."

Underpinning much of what regulators have been doing since the famous Pittsburgh declaration of 2009, there is this simple idea: 'If only we had enough information, we could head off some of these problems before they got out of hand.'

It starts with the declaration itself, which by now is probably etched into the minds of scores of market participants, but still bears repeating because in three sentences it sums up so much:

"All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."

To paraphrase Donald Rumsfeld, the world's OTC market was a known unknown. The G20 reckoned it was possible to turn that into a known known. More than three years since Pittsburgh, the information has now begun to flow.

On December 31, 2012, swap deals began

to be reported to the Commodity Futures Trading Commission (CFTC), as part of the Dodd-Frank legislation and just in time for the G20-mandated deadline. This September, similar information will start to be reported in Europe as a result of EMIR. But will regulators be able to make sense of the data? And what will they do with it?

Cato believes a big problem is that regulators don't appear to have a starting framework.

"Throughout the regulatory process, it's not always clear that there is a theory or framework of what they're trying to achieve. Certainly, a lot of it comes out of an AIG-driven sense that, 'If we just monitor and centralise risk in our derivatives and swap markets, we'll know where everything's at, and we can stop bad things from happening'," he said.

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