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Futures vs CDSs: the case for regulated markets

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In less than a month, NYMEX crude oil futures have dropped about 15% in value. Other commodities ranging from precious metals to agriculture have had significant drops as well. Even for the traditionally volatile commodity markets, this is somewhat unusual and has led many people to scratch their heads to figure out what’s happening. Is this simply a pause before the inexorable rise continues? Were there speculators that blew up and are rapidly unwinding their positions? Was there indeed a commodity bubble that has now been pricked? Or are market forces acting the way they’re supposed to, with demand declining as the world’s economies slow down?

Despite the confusion of what exactly is going on in the commodity markets, one point bears mention: no one is worried about what the true value of the September NYMEX CL contract is, or whether the counterparty to their future will be able to deliver as contracted. You can find out the price to the penny, and if you buy and hold a contract, you will get your 1000 barrels of light, sweet crude in Cushing, OK come hell or highwater. In other words, despite an impressive and unexpected 15% drop in a month, the normal market functions of price discovery, liquidity, counterparty guarantees, etc, exist and continue to work fine.

Contrast this with OTC derivatives such as CDO/CDS/MBS securities where the biggest problem has been the lack of a functioning market at all. Much of the turmoil in these markets is not because there are no investors interested in these securities per se as that in the absence of fundamental market infrastructure such as accurate prices, counterparty guarantees, and standardized, easily understood contracts, not even vulture investors want to touch this stuff, even if there might be money to be made.

So why have futures markets survived such volatility while OTC markets have essentially been destroyed? IMHO, it’s not for these reasons:

  1. Market size. The notional value of the CDS market has been estimated in the tens of trillions. Far in excess of the notional value of commodity markets. Yet CDSs collapsed while futures haven’t.
  2. Liquidity. OTC securities had large dealers and bankers who were contractually obligated to make a market in the securities they created.
  3. Leverage. Both OTC securities such as CDOs/MBS/CDSs and futures are highly leveraged.

Thus, I’d argue that there is no reason intrinsic to the nature of either OTC securities or futures that would naturally make one instrument more susceptible to market breakdown than the other.

I would assert that the difference lies soley with the differing regulation of these markets. The regulation and oversight of futures has created a market for highly levered securities that is able to continue to function despite large, rapid, unexpected, and unexplained changes in price (such as we have been seeing this past month). In contrast, OTC security markets collapsed (by which I mean the market itself, not the price) by last year when price declines were less than 15% (remember when it was shocking that some AAA tranches may sell for <95% of par?).

So far, the collapse in oil prices has not required emergent Fed intervention to maintain the stability of the strategically important oil market. In contrast, the collapse of OTC security markets has necessitated the creation of several emergent lending facilities, the bailout of BSC, and now possibly the GSEs. And markets still remain frozen after nearly a trillion dollars of government liquidity and direct intervention.

Stephen Cecchetti made a similar observation last year in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.
. . .
The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

While Amaranth and LTCM were individual firms, I believe Mr. Cecchetti’s observations are generalizable to the behavior of their respective markets as well. Standardized contracts, exchanges, and clearinghouses are three of the primary institutions through which the government regulates and supervises futures trading. They have been successful in maintaining functional markets despite tremendous leverage and volatility. Perhaps it’s time to bring them to the rest of the derivatives world…

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11 comments

  1. Steve

    Agreed on the importance of an exchange back-stop for derivatives, but bear in mind that huge volumes of OTC energy derivatives are traded. A large part of Amaranth’s losses came from OTC trades, and the fact that nobody else blew up with Amaranth had to do with the particular positions of the counterparties and with Amaranth selling its book at its decimated value.

  2. STS

    This is an excellent illustration of the way well designed market mechanisms (including regulation) can add enormous value to free markets.

    The debate shouldn’t be “regulation vs. no regulation”, it should be “good regulations vs. bad regulations”. Not all regulations are alike.

  3. Tom Lindmark

    Nice article. No obvious truths at all. Just kidding. Well thought out and well written.

    Not a great fan of regulation but what you propose makes some sense.

  4. David Merkel

    The trouble is, there is a need for customized, tailored derivatives. Exchanges can only do vanilla…

    Here’s the test. Try moving interest rate swaps to an exchange. They are pretty vanilla. If you can do that, then try swaptions, currency swaps, etc.

    Try credit and mortgage derivatives later… I don’t think they will work in an exchange format because of the need for uniqueness in exposures.

  5. Lune

    Steve-
    You’re right that the particulars of the circumstances surrounding Amaranth and LTCM make the comparison more complex than merely exchange-traded vs OTC markets. But that said, if what you say is true, that Amaranth blew up because of their OTC positions, then trading firms should be supporting the move to exchanges since that mitigates some of the market factors that did in Amaranth. OTOH, I’m sure they make lucrative fees off the inefficiencies and uncertainties of OTC markets, so they’d be loath to give that up…

    STS-
    Absolutely. Unfortunately, good regulation that works smoothly becomes so embedded in the woodwork that its presence is hardly noticed, while bad regulation causes problems and is always noticed. Thus, people get into arguments about regulation vs. no regulation because the only regulation that’s extensively noticed is bad regulation. Call it the squeaky wheel phenomenon…

    Tom-
    Thanks. Will try to stay away from claims of obviousness in the future :-)

    David-
    I’m not a derivatives trader, so I’ll defer to your expertise. But I’d wager that a lot of the purposes served by customized derivatives can be adequately fulfilled by standardized instruments as well. For example, standardized stock options can be combined to execute some pretty specific strategies like collar spreads, butterflies, condors, etc. Similarly, while one standardized instrument may not fit your need exactly, a combination of several probably would.

    At any rate, the loss of some flexibility and customizability is a small price to pay for the advantages of a more robust market (does any option trader really lament not being able to buy 3 year leaps that expire on April 23rd or something?)

  6. Anonymous

    Customization of derivitivies adds opaqueness. The opposite of opaqueness, transparency, is the quality that makes the commodities markets attractive.

    As we are now seeing opaqueness works ok untill ripples in credit markets appear and then few are interested in an opaque product that they cannot readily understand. Fear overcomes greed.

    For derivitives to remain attractive in normal and roiled credit markets they need to be readily understood by all players…Like oil is oil (with differing grades), wheat is wheat (with differing grades), etc. Somehow, transparency will have to be introduced into derivatives products if they are to remain attractive in good times and bad.

    River

  7. tz

    I would argue that the OTC markets were liquid because of the “contractually obligated market makers”. If so there could be no case of a “no bid”.

    Also futures and the rest has a “volume” published for each contract, stock, etc.

    A market maker is NOT an exchange, some amorphous obligation is not volume. If they could be traded, why weren’t they? The prices had to change over time, so there should have been a daily bid-ask.

    Or perhaps we have different definitions of liquidity, and yours doesn’t require any trading volume.

    Perhaps an exchange can handle large price drops maintaining liquidity (and having both longs and shorts). But a desk somewhere can’t deal with a million sell orders with no buy orders.

  8. Anonymous

    The problem with standardization… decreased bid/ask. Thus, the banks/brokers will only come kicking and screaming. It will be best for the market in the end. Adios middleman fat. Same fate awaits mortgage/interest rate fee racket that fell upon the equity commissions pyramid.

  9. Juan

    Lune,

    While I very much agree with the thrust of your post, only want to note that the Commodity Futures Modernization Act of 2000 was also a modifiction of the Commodity Exchange Act. Contracts executed on electronic trading facilities, and bilateral swaps, were effectively made exempt from most CFTC regulation. (“Enron loophole”)

    So far as Amaranth, the size of its calendar spread bets were, well, extreme and, after NYMEX began trying to impose limits, the fund was able to offset through the ICE. (“London loophole”?)

    My point? Commodities’ trade has been increasingly deregulated and de facto unsupervised rather than the contrary and that, in conjunction with reallocation strategies etc, this may well have contributed to the commodity price run up (which, IMO, was more interesting than the recent decline).

  10. Anonymous

    I disagree wholeheartedly.

    The reason that futures markets have better volume (the contracts that survive over time anyway), trading liquidity, etc is due to the standardization of the contracts AND the fact that you have substantial credit benefits through the exchange ownership (or public companies today).

    If someone brings me an oil futures contract for sale “at a discount” I could easily look up the price on the exchange and consider buying it or not buying it, but if someone brings me a structured note with odd terms I’ve never seen before and credit risk derived from some 3rd party I’ve never heard of, there’s no way to easily evaluate the offer, so there’s almost ZERO possibility I’d even look at the so called “asset”.

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