naked capitalism

For those who have not come across him, Satyajit Das is a hard core derivatives expert, having worked with them in enough markets and enough vantage points to very well versed, which in his case means thoroughly jaded. His book for laypeople, Traders, Guns, and Money. manages to be very informative, somewhat geeky, yet engrossing and funny.

Das is a card-carrying critic of credit default swaps, and parses the proposed market reforms, In a nutshell, he thinks they won’t make things better, and could increase systemic risk.

One of the key issue he flags is clearinghouse failure. The way any exchange or clearinghouse works is that users post initial margin and then add collateral if the instrument price moves such that the initial margin is now insufficient.

The problem with CDS is they are not derivatives in the normal sense. They are not priced in relationship to an underlying instrument or benchmark; they are a way to trade event risk. As such, there is no good way to determine how much initial margin is appropriate (this is Das’ area, and if he says it’s an issue, it is). That is in no doubt partly due to the fact that CDS “jump to default” meaning the prices spike massively when a company actually defaults. That is the big stress event, when more collateral has to be posted. Those moves are probably bigger than anyone would be willing to post as initial collateral.

That in turn means the exchange or clearinghouse would be vulnerable to liquidity problems of its own. In other words, moving CDS to a clearinghouse really might not reduce systemic risk.

Das also goes through risks the industry has assumed away (for instance, that netting exposure among contracts to a net exposure is a valid way to represent the risk; Das does not see that as foolproof).

He also states quite clearly that innovation is no longer about problem solving or creating value for customers but regulatory evasion and using complexity to extract higher fees from customers.

The statement I found most striking in his general comments (which are mingled in with his analysis) is that derivatives drained rather than added liquidity. He does not elaborate. I assume he means during the crisis, rather than in general, but anyone who can shed light is encouraged to speak up.

From Das:

Proposals for over-the-counter (OTC) derivative regulations are consistent with H. L. Mencken’s proposition that: “there is always a well-known solution to every human problem–neat, plausible, and wrong.”

A central omission is the speculative use of derivatives. Industry lobbyists focus on the use of derivatives to hedge and manage risk promoting investment and capital formation. While derivatives can play this role, the primary use of derivatives now is manufacturing risk and creating leverage.

Derivative volumes are inconsistent with “pure” risk transfer. In the credit default swap market (CDS) market, volumes were in excess of four times outstanding underlying bonds and loans. The need for speculators to facilitate markets contrasts with recent experience where they were users rather than providers of scarce liquidity and amplified systemic risks.

Relatively simple derivative products provide ample scope for risk transfer. It is not clear why increasingly complex and opaque products are needed other than to increase risk and leverage as well as circumvent investment restrictions, bank capital rules, securities and tax legislation.

A central reform proposed is the central clearing house (the central counterparty – CCP) where (so far unspecified) “standardised” derivatives transactions must be transferred to an entity that will guarantee performance.

The CCP centralises all performance in a single entity, surely the ultimate case of “too big to fail”. Effectiveness of the CCP depends on its ability to manage risk through a system of daily cash margins to secure exposure under contracts. Failure to meet a margin call requires the CCP to close out the position and offset any losses against existing collateral.

The level of initial collateral posted must cover the fall in value from the last margin call….. Traders want the maximum amount of leverage by reducing the amount cash posted.

Collateral models are based on historical volatility that may underestimate risk. For some products, such as CDS contracts, establishing the required levels of collateral required is difficult. Cross margining where traders can net all open positions expose the CCP to correlation problems in the offset methodologies. Additional problems may arise from the use of multiple CCPs.

There are significant issues in pricing and valuing contract and, for some products, reliance on complex models. The CCP assumes the ability to value contracts that relies, in turn, on liquid markets in the instruments, an unrealistic condition as events have showed.

Mis-selling of “unsuitable”derivative products to investors and corporations remains a problem. Expertise of purchasers is sometime inversely related to the complexity of derivative products. Given significant information and knowledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should have been considered.

Complex risk relationships created by derivatives are not addressed. AIG’s problems related to margin calls based on current “market” values on its derivative contracts. The CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources.

Systemic effects, such as the impact of CDS contracts on risk taking behaviour and also dealing with financial distress, are ignored. Concentrated market structures, where a handful of large dealers dominate dealing, are also not addressed….

Familiar dictums – improved disclosure, transparency and operational processes – have been tried before with limited success.

The unpalatable reality that few, self interested industry participants are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.

Until regulators and legislators understand the central issues and are prepared to address them, no meaningful reform in the control of derivative trading will be possible.