Thursday, January 29, 2009

Congress Drafts Legislation to Restrict CDS Futures

Congress has drafted legislation today to begin to restrict credit default swap futures only to those who plan to take delivery. If this goes very far, it could panic the market. This is only the first shot from the Democrat-controlled Congress. Will they do the same in the grain, crude oil, and other futures markets as well? They've threatened to! This will dry up liquidity and drive capital to overseas markets. It will literally amplify the very conditions that Congress hopes to prevent.

By restricting the capital markets in this way, Congress risks the following:
  1. Capital will flow out of the United States to futures exchanges in other countries. This, in turn will drive the Dollar lower, and commodities prices will move higher. Money and commodities flow to places where they are welcome. If Congress creates an unwelcome environment in the United States, both the capital and the commodities will go elsewhere. Can the U.S. afford to create long lines at gas pumps by creating a fuel shortage here? Can the U.S. afford to see capital flight to other countries, collapsing the Dollar and run the risk of the Dollar being dumped as the world's primary reserve currency?
  2. Liquidity will dry up, giving greater power to large market participants to control prices and manipulate the markets. George Soros is a master at manipulating small, illiquid financial markets. Remember the Hunt Brothers and their manipulation of the silver market? As prices rose, more and more participants entered the market, until the Hunt Brothers lost control and they could no longer manipulate the small silver market. Liquidity brought an end to their manipulations. Strong liquidity in any futures market is critical to prevent any market participant from exercising too much control.
    One reason for the current crisis is that derivatives products were created for which there was no market. A market without liquidity exacerbates the wild price swings when a single market participant need to change positions or exit the market and can't find a willing buyer or seller. Liquidity prevents this. This is precisely what has caused the current crisis. The absence of a liquid market eventually caused the government to step in and buy toxic assets for which no liquid market existed.
  3. It will make price discovery more difficult and constrained. One of the reasons that this financial crisis occurred is because so many derivatives products were created without price transparency. This action will reduce transparency, and amplify the very problem that created the crisis in the first place.
If they were wise, Congress would, instead, take action that would encourage greater transparency and liquidity. This will have a negative and destructive effect on the futures markets. It won't improve conditions. It will amplify the very conditions that created this imbroglio in the first place.

We are now beginning to see signs of over-regulation that harms financial markets. We are seeing signs of a brewing trade war and trade sanctions. These are precisely the conditions that multiplied and deepened the Great Depression. Congress must have the wisdom to resist the temptation to engage in populist actions that will make matters worse. If they don't, everyone will pay the price for their stupidity!