Regulation Watch: 'Just So Stories' Surrounding Derivatives Are a Puzzle

All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed. Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether.

Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared. (Clearing is a way of mutualizing default risks. At present, default risks in a particular contract are directly limited to the buyer and seller.) (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac? I do. Does this inspire confidence? Self-answering question.) These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.

These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements. That this immense market is and was in fact arguably the largest market failure in financial history.

And these markets are indeed immense. According to Bank of International Settlements data, notional (”face”) values of these instruments totaled $683 trillion in June, 2008 (right before the onset of the financial crisis), and their market values totaled $20 trillion (ballooning to $34 trillion by the end of 2008).

Moreover, these markets had grown dramatically over the years–at a double digit annual pace. They also dwarfed the market for exchange traded (and cleared) derivatives. The BIS reports that at the end of 2007, total notional values of outstanding contracts traded on exchanges were $28 trillion, which had shrunk to less than a mere $20 trillion at the end of 2008. (I won’t go into the quibbles over the interpretation of these numbers, which make true apples-to-apples comparisons impossible. Suffice it to say, difficulties of interpretation duly considered, the exchange traded markets are huge, but the OTC markets are HUGE.)

But our betters on Capitol Hill think that these collective results of the individual decisions of thousands of informed participants with major skin in the game are wrong, wrong, wrong. They know better. EVERYTHING should be traded on exchanges. EVERYTHING should be cleared. The emergent order is fundamentally flawed; a constructed one must be substituted for it by legislative fiat.

This assertion of systematic, immense market failure demands a coherent explanation. It is, to be honest, quite hard to find one. In this post and some that follow, I’ll examine some of the attempts at explanation.

Cliffs’ Note version of my conclusion: I’m still searching for a coherent story.

One of the most commonly heard stories is that OTC derivatives are enormously profitable for big banks due to the lack of transparency in the market. Exchange trading and clearing would shrink profit margins, costing the banks big money. So they have deliberately kept the market dark in order to enhance their market power and their profits.

Of course, all dominant incumbents want to maintain market arrangements that protect their market power and monopoly profits. This is why GM is enormously profitable due its continued dominance of the automobile market.

Back to our regularly scheduled reality.

To justify the profit protection story, it is necessary to demonstrate the existence of entry barriers. It is possible for banks to charge their customers supercompetitive prices persistently only if there is no possibility for competitors to undercut these prices (where the idea of “price” should be interpreted broadly to incorporate all of the costs that customers pay to trade derivatives.) There are, however, strong reasons to believe that such entry barriers don’t exist, or aren’t sufficiently strong to explain the dominance of the OTC markets.

Let’s consider for a minute the legislative proposals. They want to force trading onto exchanges. They believe that this trading will be cheaper and more efficient due to greater transparency and competition, and share default risks more efficiently, than the current OTC markets. But exchanges already exist. For years they have been striving mightily to make inroads into the OTC derivatives markets. Futures brokerage firms have also been trying mightily to market their services to the customers of OTC dealers. Exchanges have launched head-to-head competition in many areas–and failed miserably in most of them.

If exchanges are really cheaper, because OTC dealer banks exercise market power and charge supercompetitive prices, why haven’t the exchanges made greater penetration? Why haven’t they drawn business from the OTC dealers? Why has the market share of OTC derivatives grown?

I’ll wait. Barney? Chris? Tim? Gary? Mary? [Humming quietly to myself.]

Put differently: the alternative market arrangement that the DC crowd says is more efficient and cheaper has been available to the allegedly poor, exploited customers of dominant dealers for years, and they’ve chosen to trade with the dealers nonetheless. How to explain this? Battered spouse syndrome? Masochism? It is a puzzle, no?

But it gets better. There are many markets in which virtually identical products trade OTC and on exchanges. In many of these markets, consenting adults knowingly choose to trade the uncleared, bilateral OTC contracts. Why would that be if OTC markets are beset by market power that inflates the costs that customers pay?

Moreover, there are cases where clearing has developed organically in an OTC market without the benefit of a government mandate. Most notably, clearing has grown dramatically in OTC energy derivatives since 2003. This demonstrates that clearing can succeed competitively where customers want it. This undercuts the idea that clearing (or exchange trading) is at an inherent competitive disadvantage relative to OTC dealer. Ironically, and tellingly, this development has occurred precisely when the firms that dominate the OTC financial markets–e.g., Goldman Sachs (GS), J.P. Morgan (JPM), Morgan Stanley (MS), and other big banks–began to dominate trading in OTC energy derivatives. How come they didn’t strangle the clearing baby in the crib to create and protect a privileged position in the energy markets?

In sum: there have been vigorous attempts of the putatively cheaper, more efficient exchange trading platforms to enter the market, suggesting that entry barriers do not preclude such competition. These competitive efforts have often failed, and have certainly failed to displace OTC trading. Where given a choice, customers sometimes choose cleared or exchange traded products–and oftentimes don’t.

Which calls into serious, serious question the received story as to why the inefficient, opaque, market-power ridden OTC market has survived and thrived. Instead, this “explanation” appears to be yet another of the many Just So Stories that have proliferated in the aftermath of the financial crisis; a superficially plausible explanation that does not withstand scrutiny.

But on the basis of such Just So Stories, we are supposed to countenance the complete re-engineering of the world’s financial markets.

Comments

[Tom Armistead:]

You're missing the point. The point is, to get all derivatives on an exchange with an audit trail so the manipulators can be investigated and brought to justice. You seem to forget that when the SEC and NY AG went to investigate the long CDS, short and distort crew that the outcome was the perpetrators claimed they didn't have to produce records and that the SEC had no authority. They got away with it.

Another consequence of trading everything on an exchange will be the ability to price both sides of the position to the same standard. A cursory review of the collective derivative assets and liabilities of the 5 major banks reveals that the assets exceed the liabilities in every case. This is a zero sum game, there is no way everybody is making money, but that's how they keep the books.

In point of fact, if standardized contracts were traded on exchanges, and long positions marked to the bid, and short positions to the ask, collectively all participants would be reporting liabilities greater than assets, rather than the reverse.

Quite frankly, the industry for which you are an apologist has expanded far beyond its socially useful purposes, into a giant bubble and casino that still endangers the financial system. Geithner, Gensler and Shapiro are very fortunately on the same page here, and it is the right one - this industry needs transparency and prudential regulation to prevent fraud, abuse and manipulation which endanger participants in the real economy.

Nov 13 06:29 AM

[Andrew Butter:]

Very nicely argued, but here is a question for you:

How come the US Government felt it necessary to go out and pay off CDS contracts written by AIG at 100 cents on the dollar?

The logic there was that the financial system would implode like a chain reaction if they didn't. Likewise a big part of the uncertainty and fear generated by the Lehman collapse was what would happen to their derivatives.

Good regulation makes sure, for example, that players don't offer up the same collateral to ten or twenty different people, that's fraud and that how as Tom Amistead points out, there is something very fishy in the way those are accounted for.

If the government or the taxpayer is exposed to this type of fraud they have a legitimate place ensuring that it doesn't happen.

Nov 13 06:55 AM

[Jim Moser:]

With respect to proposals to require exchange trading, I expect the liquidity needed for exchange trading will, for most part, be inadequate. Yes the dollar value of current OTC contracts is very large, but that is because the contracts themselves have large notional values. The number of contracts traded on a given underlying is quite small, too small I expect to justify placing those trades on an exchange. If adopted, my expectation is that notional values will be pushed toward levels generally seen on exchanges. The ultimate effect will, I think, depend on the extent to which firms that currently opt to establish their positions via OTC arrangements decide to restructure themselves so as to trade smaller exchange-listed contracts.

With respect to the clearing aspects of these proposals, professor Pirrong may be overstating the market's wisdom. The failure of AIG does indicate weakness in the structure of the CDS market. These contracts are among the hardest to value, hence differences in valuation approaches are significant. For those contracts, a central counterparty would appear to be the better choice. But at its peak, CDS constituted about 6% of the OTC contracts by notional value. Settlements for the other 94% of those contracts (again by notional value) went quite well and where concerns did appear they owed largely to institutions weakened via exposure to CDS contracts--hence, at best the effect was indirect. So the clearing proposals amount to using an overly broad brush to fix problems that arose in a narrow segment of OTC contracting. Requiring clearing for all contracts imposes, for most of those contracts, a cost that will exceed the benefits gained. That cost will deter some entrants.

Nov 13 08:47 AM