Satyajit Das Weighs in on OTC Derivatives Proposals and Finds Them Wanting

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.

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  1. Views By a

    "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."

    I'd take issue with this because it sounds: (1) like there was a time when value *was* created; and (2) it leaves out a big reason for innovation, which is tax arbitrage (I would hope Das doesn't put that as adding value).


  2. cojock

    Das makes a point I was making a few years ago in Lausanne at a pretty high level conference concerning "Economic Terrorism" ie the susceptibility of marketsand the financial system to meltdown caused by malicious action.

    I was speaking in relation to energy markets (I used to be a Director of a global energy futures exchange) but the principle is the same in any market with a central counterparty. As I said at the time, the only difference between a Hedge Fund and an Economic Terrorist is motive.

    As Das points out, CCPs constitute "single points of failure".

    The risk position of CCPs is a close analogy to that of (say) Freddie Mac and Fannie Mae. Credit Risk and Price Risk are analogous: Banks' regulatory capital underpins credit risk: CCP capital and margins underpin market price risk. So CCPs are exposed to market discontinuities in the same way that Freddie and Fannie were exposed to credit market discontinuity.

    In my view the solution is the same as that taken by the military when they built Darpanet (thereby kick-starting the Internet) in order to decentralise command and provide resilience in a war situation. We must evolve a new generation of networked and decentralised "Peer to Peer" markets – which I refer to as Market 3.0 – and spread the risk more evenly through the system.

    In fact, these "Peer to Peer" solutions are emerging rapidly in any case and IMHO the role of Government is merely to recognise and facilitate what is going on anyway.

  3. skippy

    @Views By a,

    De-construct that a bit more and you hit gold, state of mind to the issuer of adjective's, in time frames that bring back the good old days.


    P.S. A drive by thought..I once had a West Lake girlfriend…who's grandparents lived in Bel Air with tattoos upon their wrists…the 50's lithograph posters of skiing in Europe… still fresh in their tomb…on 80's viewing…an old bomb shelter out back…brought upon me a disconcerting warmth…reflection…days gone by…still feel its effects decades later…but stride to learn other wise.

    What a hack eh…Richard K. sorry for the squelch to your spectrum.

    verification: berall

  4. vlade

    Hallelujah! I was pointing I don't know for how long that the "move it to exchanges and she'll be right" crowd lacks basic understanding of CDS risks. You cannot reasonably margin products with infinite gamma (except by full amount, in which case it ceases to be a derivative). Full stop.

    There are also strong reasons why even something as simple as swaps cannot be reasonably transacted on exchanges (for commercial clients) – it implies putting down margin, which has very strong implication on cashflows of the commercial clients. There have been numerous cases of small/medium corporates getting into problems when they got missold futures and then had to post huge margin calls (for which they didn't have free cash). It helps to remember the old one – margin call can sink you even if your bet was right.

    Think about what the exchanges are for – removing cpty risk. The only way to remove the cpty risk is collateralization/margining. To be able to do it, you have to have access to free cash to do so. Small/medium corporates often don't which is why they have to pay more for the credit risk the bank carries.
    How would you like your mortgage to be (cash) collateralised, so when the value of your house drops below the value of your mortgage (that is, the NPV of the amount outstanding and the future cashflows, not just the amount outstanding), you'd have to post cash to the bank? Talking about moving IR swaps to exchanges is the same – as far as credit risk goes.

    That is not to say that it would not help to have a central clearer (so that data on the transactions can be kept and prices would be more transparent). But it's not the same as removing credit risk on exchanges.

  5. Marcf

    Re: liquidity. I was having this conversation yesterday with a GS banker. I believe Aug 07 was a liquidity drain due to naked CDS on subprime tranches.

    Take Paulson et al. They bet on implosion of subprime via naked CDS on toxic tranches of CDOs. The stuff blows up. Ratio of naked CDS to CDS is 4/1 so you have 5 units of bad debt materializing. They pay 10% for 2 years creating "liquidity" of 10% of nominal. When it blows up, liquid settlement needs to come up with 100% of nominal. 10 times the liquidity injected is taken out. This assumes a cash settlement which is not always the case.

    In Aug 07, payment of speculators created an initial drag on liquidity. They could probably not pay in kind as the market for the securities evaporated.

    The problem with CDS in general and naked CDS in particular is that the numbers involved are huge (debt x 4). Not all derivatives are created equal.

  6. Siggy

    Derivatives are contingent contracts. If you wittingly sell or buy a contract for which you know that in the event of the specified contingency you will be unable to perform, in my view, you are perpetrating a fraud. Thus, the economic viability of most derivatives is questionable at the outset. The esoteric arithmetic is unnecessary, if not pointless. Had AIG been run thru bankruptcy, the contracts could have been rejected and the counterparties could then get in line for their share of the proceeds of liquidation. The fact that that did not happen smells worse than Tea Pot Dome.

  7. Hugh

    My reading of Das was that CDSs drain liquidity out of the market by diverting it into speculative ventures. This is true initially and even truer when they blow up.

    As for clearinghouses, my understanding is that they assume the counterparty risk in the case of a default. In a general economic downturn such as we are currently experiencing, it would seem the likelihood would be high that there would be multiple defaults and insufficient collateral to offset losses to the extent that it would blow up the clearinghouse.

    Again there is no at all for naked CDSs. If you want to gamble, go to Vegas. As for equity backed ones, they simply give a patina of justification to deals that otherwise should not be made.

  8. Marcf

    Did AIG commit fraud by booking revenue each year from deals it knew it could not honor? perhaps.

    Did the investor that took a CDS commit fraud? NO. I believe CDS are economically useful contracts by moving risk to bearer.

    Did the speculator that took a naked CDS commit a fraud? Legally no. But from a economics standpoint he was betting with capitalism weapons of mass destruction. The problem is the size of the deal. Nominal materializes at time of default. Nominal is 4x real debt structure.

    One has to be careful in making generalities out of credit derivatives.

    I do agree that equity backed derivatives are a different beast imho. If naked short interest was 400% of a stock, do you really think that stock would survive? Is that even possible? can naked short even represent 4x equity holding? Can you imagine the liquidity drain that would be?

    Numbers…. economics, physics and biology all depend on "scale". The scale decides what is relevant and not.

  9. Francois

    "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."

    cojock wrote:
    "As Das points out, CCPs constitute "single points of failure"."

    Seems to me that CDS's should be banned outright.

    Can anyone point to a true added value feature of CDSs benefiting someone else than a few speculators?

    I mean, what's wrong with options and futures? Isn't that enough?

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