Portfolio Transparency Is Not Optional

| About: American International (AIG)

Of all the lessons to be learned in the wake of the global financial crisis, I believe lesson #1 has to be:


Part of this has to do with enforcing more stringent disclosure rules, and consistently applying mark-to-market rules across portfolios and firms. But the other part is more structural. The worldwide financial services boom of the past 20 years has largely happened off-balance sheet, in the realm of the over-the-counter [OTC] derivatives market.

When we talk of bank, investment bank and insurance company balance sheets in the hundred of billions of dollars, with a few firms having broken the trillion-dollar mark, these amounts pale in comparison to the tens (hundreds?) of trillions of notional value of outstanding OTC derivative contracts. Nouriel Roubini talks about the "shadow banking system;" the real shadow banking system is the OTC derivatives market, greater in scope than anything we could have imagined a mere two decades ago, creating risks and opportunities of a mind-boggling scale.

The key question to be answered is:

Do we really have a firm grip on the exposures arising from these opaque agreements, and understand how these contracts lead to a deeply interconnected (and, therefore, highly correlated) financial system that can collapse if only one link in the chain gets broken?

Sadly, if the events of the past few weeks are any indication, the answer to this question is certainly not.

I spent some time thinking about this in June 2007, when I was concerned about the true amount of risk embedded within dealer trading books:

Wall Street risk management practices and infrastructures have been substantially upgraded over the past 10 years, partly due to the fact that risk manager compensation levels have shot up as its importance in the money-making process (either by protecting against financial loss or guarding against the "headline risk" of a blow-up) has become apparent. And this is completely appropriate, and more so due to the skyrocketing OTC derivatives volumes churning through the system. The question is: what is the true extent of the residual exposures being borne by the Wall Street dealer community, and how is revenue being recognized relative to the ongoing exposures carried in dealer trading books?  VaR won't tell you. These numbers simply aren't available. This is just something to keep an eye on as more and more asset hedgers look to buy optionality. Because someone will be booking these hedges. And they will be in sizes far in excess of those available through the listed markets. Which leaves the dealer community. Hmmm...

One of my key concerns then was the lack of depth of the listed derivatives markets, and that the bulk of risk management activities would happen in the shadows off dealer OTC desks. I'd say that prediction has pretty much come to pass.

This past May I thought more concretely about the importance of a deeper, more fully-developed exchange-traded derivatives market to deal with issues of transparency, rising trading volumes, exploding credit exposures and non-standardized documentation:

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota's success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.

What I said in May is even more true today, and the reasons I cited for why a move towards listed derivative exchanges has to happen has been validated by the financial melt-down. Would AIG (NYSE:AIG) have gone down as it did if its derivatives book was largely executed on an exchange, with full transparency and price discovery? I doubt it. If exchanges were the central clearing-houses for derivatives transactions, would we be worrying so much about counterparty exposures and the interconnectedness of these exposures? No. Opponents to this plan will say "we'll lose the ability to customize our contracts." In a 100% exchange-traded world, yes. But there are two valid responses: (1) almost all complex risks can be decomposed into an array of simple and straight-forward risks that can largely be hedged; and (2) if not, OTC contracts can still get done, just with a far higher degree of disclosure and transparency than has been required previously. I'm not suggesting that all derivatives transactions either should or can be moved to exchanges; but I'd wager that at least 80-90% of current OTC volumes can.

This means that global exchanges have a massive opportunity in tomorrow's world, where derivatives trading dwarfs listed and OTC stock trading volumes. This also means that investors and other consumers of financial statements will have much greater clarity on this off-balance sheet exposure, and the risks that have exponentially risen every year since the mid-1980s but with little transparency as to its amount, character and counterparty concentration. Given the re-engineering of our financial system in light of the current crisis, now is the right time to shine a bright light on this critical issue and to effect change. This is one trade where nearly everyone wins.