New regulations for the derivatives markets will not prevent future corporate failures similar to Enron Corp.’s and in fact might make failures more likely in the future, according to a new report by the International Swaps and Derivatives Association (ISDA), a global trade association representing participants in the privately negotiated derivatives industry, which includes interest rate, currency, commodity, credit and equity swaps, as well as related products.
The study, titled “Enron: Corporate Failure, Market Success,” concludes that although derivatives were part of the Enron mess, they “played no essential role.” The real causes were failures in Enron’s corporate governance, accounting and disclosure. It was Enron’s corrupt use of the derivatives market and efforts to circumvent existing controls and conceal its activities, rather than the derivatives themselves, that ultimately led to its failure.
Furthermore, there “is no evidence that the market failed to function,” the report stated. “About 800 credit default swaps involving over $8 billion in notional were outstanding on Enron, all of which appear to have been settled without disputes, litigation or mechanical settlement problems. In addition, obligations associated with the close outs were apparently paid, where required, to Enron by the counterparty, while counterparties that are owed money by Enron will have their claims considered by the bankruptcy trustee. Finally, the disappearance of Enron as a trader appears to have had little market impact as volume moved to other trading firms. It is difficult to see failure in the way the market functioned.”
In the end, the market “exercised the ultimate sanction” over Enron, the study noted.
If there was no market failure, there is no need for additional derivatives market regulation, according to ISDA. Furthermore, it is likely that additional regulation, “by increasing moral hazard and decreasing legal certainty, could have the unintended consequence of making futures failures and market instability more likely along with increasing the cost and decreasing the availability of risk management tools like swaps,” the study said.
Enron’s problems were the result of two conflicting strategies. One was to invest in energy, telecommunications and technology businesses, which require substantial debt. And the other was to become a major swaps dealer, which required substantial creditworthiness. Rather than change to a realistic strategy, Enron executives chose to exploit accounting rules and corporate governance principles to maintain the appearance of creditworthiness.
“Their unsuccessful effort is not an indictment of market discipline but a confirmation of it,” ISDA said. “It would be ironic if policy actions designed to correct perceived market failures were to have the unintended consequence of undermining a self-regulatory structure that has proven that it works and works well.”
The group’s report was released after the failure of an attempt to add new derivatives regulation to the energy bill currently under consideration in the Senate (see Daily GPI, April 11).
For a copy of the study visit ISDA’s web site at www.isda.org.
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