On June 17, the White House and the Department of the Treasury revealed plans to regulate over-the-counter derivatives. The proposals unveiled also included a host of other regulatory measures designed to avoid systemic risk in the financial markets. In a recent interview with Knowledge@Emory, Nicholas Valerio III, associate professor in the practice of finance at Emory University's Goizueta Business School, discussed the reform proposals, the problems with over-the-counter derivatives, and what's ahead for Wall Street. At Goizueta, Valerio teaches classes on derivative assets to undergraduate and MBA students as well as an advanced derivatives course to full-time MBA students. His areas of specialization include equity options and futures, investment management, and financial markets. In addition, he advises and accompanies MBA students on the annual New York Stock Exchange trek to further enhance the learning experience.

Valerio recommends Knowledge@Emory readers pick up two bestselling finance books to get a better perspective on risk management and the psychology and history of the financial markets-Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein and The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb.

Knowledge@Emory: Can you briefly explain the risks that over-the-counter derivatives, such as credit default swaps, present, especially when there is real difficulty in calculating the counterparty risk?

Valerio: One of the major risks that over-the-counter (OTC) derivatives present is counterparty, or default, risk. This is the risk that one of the two parties to the contract does not ultimately fulfill their financial obligation. When exchange-traded (listed) derivatives are traded, there are mechanisms in place to reduce counterparty risk. A clearing corporation exists to act as intermediary to all trades, and therefore absorbs that risk. Additionally, margin requirements-essentially a financial deposit-are imposed on both parties to the trade, to demonstrate their financial resources. And then, since trading occurs in a public market, price discovery is available, which simplifies the marking-to-market process. Finally, the public markets themselves are directly regulated by various government agencies.

In the OTC derivatives market, the burden falls on each counterparty to verify the financial stability of the other. Institutions typically will signal to potential counterparties their financial strength by maintaining a large base of capital. But none of the mechanisms of the public marketplace are required in the OTC market. Furthermore, in the OTC arena the level of regulation of the participants is determined by their role in the financial markets. But there is no direct regulation of this marketplace itself. Without direct regulation of the OTC market, there is no pricing transparency, nor centralized reporting of derivatives positions, and therefore the inability to measure the size and scope of the market.

Knowledge@Emory: Given the news of late, it seems that many in the financial press want to paint all derivatives with a broad brush. Can you tell us why certain key derivatives, such as options, futures or swaps, are actually good for the market? Maybe you can define derivatives in the broadest sense?

Valerio: In general, a derivative is a financial asset that derives its value from another financial asset, called the underlying asset. For example, the value of employee compensation options is determined by the level or price of the company's stock. In this example the options are the derivatives, and the stock is the underlying financial asset.

Derivatives are used for three different purposes. First is the hedging function, where a derivative can be entered into to offset an existing risk exposure. For example, a stock portfolio manager with a short-term bearish view on the stock market, traditionally, could reduce the portfolio's market exposure by selling stock and placing the funds in money market securities. However, the transaction's costs of trading to make this adjustment (and the subsequent reversal of the trades) could be quite high. Instead, the manager could today maintain the stock portfolio, and enter into an appropriate position in a derivative whose value is tied to a decline in a stock index. Then, if the manager's views are correct, the gains in value of the derivative position would offset the losses in the stock portfolio.

The second use of derivatives is for speculation. In this case, the derivative asset can create the risk exposure of the underlying asset itself. For the stock portfolio manager of the previous example, a short-term bullish view on the market can be expressed by increasing the stock holdings of the portfolio, or by entering into a derivative that gains value when the underlying stock index increases.

The final use of derivatives is for purposes of exploiting a relative mispricing between the derivative and its underlying asset. The goal here is to earn arbitrage (riskless) profits. Since the values of the two assets are linked by design, any deviation of their prices from a fundamental pricing relationship can be captured by offsetting positions in the two assets. If properly executed, the individual risks of the two offsetting positions will cancel out, making the gains riskless.

The primary benefit of derivatives comes from their role as a risk-management tool in the hedging function. But even in the speculative function, derivatives are still useful as a vehicle for pricing risk. And the presence of arbitrageurs ensures that fair pricing relationships will be maintained, ultimately benefiting all participants.

Knowledge@Emory: Can you briefly explain the relationship between credit default swaps and collateralized mortgage obligations? There are critics calling for the elimination of collateralized mortgage obligations (CMOs). But there are others arguing that if CMOs get eliminated, it will make it harder for Americans to buy a house or for the real estate industry to rebound. Just how true is that last statement?

Valerio: Credit default swaps (CDS) and collateralized mortgage obligations (CMOs) are both popular forms of OTC derivatives. The CDS is a contract that gives its holder the right to collect a payment in the event of default of the underlying corporate bond. The CMO is a security that provides its holder a claim on a portion of the cash flows from a pool of mortgages.

The securitization of mortgages has had a tremendous positive impact on the real estate industry. This has allowed for the efficient flow of capital from those with money to invest to those who need the money to purchase real estate. Any restriction or outright elimination of this avenue for the flow of capital will certainly have a negative impact on real estate activity, either by reducing it or making it more costly.

Knowledge@Emory: A June 11, 2009 online article in the Wall Street Journal titled How Traders Killed Value Investing talked about the influence of hedge fund managers on the market and how their interest in credit default swaps moved the pricing on corporate bonds underlying those derivatives. What is your thought on this, and what sort of regulation is needed to resolve this problem?

Valerio: I think a distinction will need to be made between funds that use credit default swaps (CDS) to hedge positions in corporate bonds, and funds that use CDS to express a speculative view on the underlying corporate bonds. In the exchange-traded market, speculative traders of derivatives often face higher margin requirements than those imposed on hedgers. So maybe we need to think about a similar mechanism for identification in the OTC market. There have been calls for centralized clearing of OTC derivatives, but that would require some standardization of these products, which would ironically take away the big advantage of the OTC market to customize products to suit specific needs. Ultimately, I think it would be more effective to work within the existing regulatory framework, but consolidate much of the fragmented oversight that now goes on.

Knowledge@Emory: The Department of the Treasury's new plan calls for SEC registration of what will probably be most hedge funds and other private pools of capital, as well as regulation of over-the-counter derivatives. What's your perspective on this plan to push for more transparency?

Valerio: I do not think it will be as effective as intended. The private pools of capital, in aggregate, are large but just a small portion of the broader financial markets. In most cases they were not responsible for the problems in the current environment, but instead that responsibility rests with much larger institutions that are already under much supervision and regulation. If new regulations were deemed to be too burdensome, you would see many of these private pools of capital moving outside of the United States.

Regulation of over-the-counter derivatives needs to be done very carefully. Most of these products are complex, and, unfortunately, their inner workings are not understood by those proposing the regulations. It would be very easy to end up with an example of the law of unintended consequences that would impose significant costs without any corresponding benefits.