Comments on: Another Sighting of a Sensible Markets Reform Proposal http://www.nakedcapitalism.com/2007/11/another-sighting-of-sensible-markets.html Mon, 23 Nov 2009 06:07:28 -0500 http://wordpress.org/?v=2.8.4 hourly 1 By: Anonymous http://www.nakedcapitalism.com/2007/11/another-sighting-of-sensible-markets.html#comment-1781 Anonymous Tue, 20 Nov 2007 22:04:00 +0000 http://www.nakedcapitalism.com/2007/11/another-sighting-of-a-sensible-markets-reform-proposal/#comment-1781 Thanks Vlade,<br/><br/>As I was reading Checchetti, I kept thinking 'yes, but...' what about jurisdictional shifts, what about customized products...<br/><br/>There seems a moreless general failure among economists to recognize the non-standard or, as you say, bespoke, quality and, I'm thinking, different evaluation models. Thanks Vlade,

As I was reading Checchetti, I kept thinking ‘yes, but…’ what about jurisdictional shifts, what about customized products…

There seems a moreless general failure among economists to recognize the non-standard or, as you say, bespoke, quality and, I’m thinking, different evaluation models.

]]> By: vlade http://www.nakedcapitalism.com/2007/11/another-sighting-of-sensible-markets.html#comment-1771 vlade Tue, 20 Nov 2007 08:54:00 +0000 http://www.nakedcapitalism.com/2007/11/another-sighting-of-a-sensible-markets-reform-proposal/#comment-1771 While I think that securities trading might become easier/more transparent if we moved all securities to exchanges, I don't think we can move derivatives there easily.<br/>As you agree in one of your comments to an earlier blog entry, there's a huge potential problem even with vanilla CDSes - I was being looked as mad when I was pointing out two years ago that there is a immense systemic problem of a chain reaction should one of the big parties went under, and because you can easily write way more protection than there is outstanding debt (and, as Adelphi shows, even though almost everything should be physically settled, people bend and cash settle).<br/>I can't imagine that an exchange would be willing to take the cpty risk on this either, and I can't see how you'd margin it and still make the contracts economical. The problem you'd run into is that if the underlying asset (on which the CDS is written) is correlated with the cpty. Then when your cpty defaults, you don't get to do the margin call anymore but the value of the asset has moved - in the worst case it defaulted and you as an exchange are exposed to potentially very significant loses.<br/>If the exchange doesn't take the cpty risk (as per futures), then there's no discernible advantage (as pricing for vanilla CDSes is relatively transparent even now). You'd get better data as to volumes/exposures etc., but ultimately, if it's not interesting for the participants, you'd not destroy the OTC market - there would always be a jurisdiction which would allow OTC and all of sudden the whole CDS/whatever market would move there. <br/>Admittedly, you could start making complicated legislation that would ensure that the banks could own (directly or indirectly) only exchange traded contracts, but that would be very complicated and would kill inovation - as any new product, or bespoke product would have to go via the exchange which might not be economical (imagine a bespoke credit/inflation/IR/FX exotic combo that a specific customer wants and you can't easily decompose into well defined constituents). While I think that securities trading might become easier/more transparent if we moved all securities to exchanges, I don’t think we can move derivatives there easily.
As you agree in one of your comments to an earlier blog entry, there’s a huge potential problem even with vanilla CDSes – I was being looked as mad when I was pointing out two years ago that there is a immense systemic problem of a chain reaction should one of the big parties went under, and because you can easily write way more protection than there is outstanding debt (and, as Adelphi shows, even though almost everything should be physically settled, people bend and cash settle).
I can’t imagine that an exchange would be willing to take the cpty risk on this either, and I can’t see how you’d margin it and still make the contracts economical. The problem you’d run into is that if the underlying asset (on which the CDS is written) is correlated with the cpty. Then when your cpty defaults, you don’t get to do the margin call anymore but the value of the asset has moved – in the worst case it defaulted and you as an exchange are exposed to potentially very significant loses.
If the exchange doesn’t take the cpty risk (as per futures), then there’s no discernible advantage (as pricing for vanilla CDSes is relatively transparent even now). You’d get better data as to volumes/exposures etc., but ultimately, if it’s not interesting for the participants, you’d not destroy the OTC market – there would always be a jurisdiction which would allow OTC and all of sudden the whole CDS/whatever market would move there.
Admittedly, you could start making complicated legislation that would ensure that the banks could own (directly or indirectly) only exchange traded contracts, but that would be very complicated and would kill inovation – as any new product, or bespoke product would have to go via the exchange which might not be economical (imagine a bespoke credit/inflation/IR/FX exotic combo that a specific customer wants and you can’t easily decompose into well defined constituents).

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