A Secretive Banking Elite Rules Trading in Derivatives
nytimes.com
nytimes.com
This was my favorite quote:
To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton.
Right.... First of all, get the name right. It's significantly been called the CME Group for years now -- and refers to the fact that this is a collection of all sorts of markets, the vast majority of which are financial derivatives. Ken Griffin proposed a very specific trading platform for CDS derivatives a couple of years back. The CBOT and CME (merged as the CME Group) meanwhile have been trading other financial derivatives, as the majority of their business, for three decades now.
The key point that is missed in all this imprecision -- is that CDS derivatives markets are not like other derivatives markets -- which are regulated. They are contracts that occur between large financial institutions only. That is the 'secret'. The rest is just the equivalent of a high school tourist at the visitor's desk.
That said, she's in the general right direction (I won't say ballpark). But yeah, it's almost like complex businesses require three levels of understanding that people go through:
(1) it's a conspiracy
(2) it's actually not so bad
(3) there are targeted ways to improve it
Instead of being pedantic and snarky why don't you enlighten us all instead of using acronyms for everything? CBOT appears to be the Chicago Board of Trade. But CDS? Is this the famous credit default swaps that helped bring about the current mess that we are in? And the banks are unwilling to have a light shone on these dealings. ? What a surprise. She doesn't imply it is a conspiracy - she actually shows that there appears to be collusion and monopolistic practices. There is no, "we think they are up to something but don't know what", it's "they are up to something and aren't playing ball".
Okay, I'll try for a little bit. I should be programming. But a little bit of history. I apologize for sounding pedantic or snarky.
In the 1900s up until the 1970s, the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) traded mostly agricultural products. A similar market existed in New York (NYMEX). These exchanges were created so that (as alluded to in the beginning of the NYT piece) wholesalers, farmers, people with a heating oil business, etc., could hedge the risk associated with the price of their commodities (due to weather, circumstance, etc.). Eventually these contracts became standardized -- they referred to the same # of bushels, and they were backed by clearing firms and central clearing houses at the exchange that served as buffer between these hedgers (who would 'hedge their bet', if they were more interested in selling at a locked in price and not worrying about the changing prices of the market), and speculators (usually local traders, or 'locals'), who would assume this risk.
These standardized future contracts fall under the category of 'derivatives', because they 'derive' from the current price of the commodities (often called 'cash' or 'cash instruments'). It turns out that there is overlap in how you create other more complex derivatives related to these futures contracts. So you can create options on these contracts. The options 'derive' from the price of the futures, etc. Sort of similar to higher order derivatives in math (so blaming 'derivatives' in general usually irks people in the industry because that's like blaming 'acceleration').
But there are different cash instruments you can use, and different ways you can form these instruments. So in the early 1980s, due to tax incentives in Illinois, and a couple of other reasons, the CME introduces the Eurodollar future. This is the first major financial future. The cash product here is interest rates (usually the LIBOR rate -- hence, the 'Euro' -- a standard short-term interest rate used by banks). So now financial institutions are starting to see that they can do this same type of hedging of their bets (they're the 'farmer' or 'heating oil producer' in this equation). If they want, they can now hedge their exposure to interest rates.
But why stop there? Futures contracts have the benefit of different taxation (capital gains taxes in Illinois are lower than elsewhere -- I don't know how much this has changed, but, e.g., this is one of key things a good reporting piece could focus on -- the justification is that speculation and capital gains from trading is risky and deserves to be taxed less -- because of the good to the economy that it provides, etc. -- but I mean, that's worth debating). And futures contracts also have the benefit that they're standardized and accessible to anyone with a terminal. So before you know it futures on stock indicies are introduced (the largest volume contract in the U.S. -- is the S&P 500 family of futures contracts). And around this time -- in the early 90s, things start to go electronic for the first time.
Bond futures are also introduced (at the CBOT). And this allows large financial institutions to offset risk more easily with their treasury bond portfolios, etc.
The key thing here though is that all these instruments, all this financial futures -- and all the options on financial futures that created -- they're all regulated. They're all closely watched by the CFTC and other regulatory bodies.
Enter the problem. Credit Default Swaps. These are non-standardized contracts drawn up between bulge-bracket firms in New York and insurance agencies to deal with the risks associated with mortgage securities. This is a huge, multi-multi-billion dollar industry that isn't regulated because it's still in its infancy and the participants have never been truly brought into the light.
Financial engineers, having seen how derivative contracts can be used to offset or control risk -- decide to draft these contracts to deal with mortgage-backed securities. The problem with mortgage-backed securities -- I don't know for sure. But I know they've been problematic from the 80s onwards. The bundling of home loans by New York has just never worked out for everyone (and Warren Buffett bailing out Salomon didn't fix the core of the problem -- in fact, arguably it glossed it over and left it as a potentially hazardous situation for two decades later -- though that's highly controversial, and just my sense -- the rest of what I said is hopefully pretty well accepted).
So creating financial derivatives for CDSes doesn't work in an unregulated manner. So seeing things collapsing, and seeing an opportunity to be involved in a huge new market, Ken Griffin proposes that CDSes should be traded in a more open manner (in 2008). CME Group (which is a merger of all three major futures exchanges in the US -- CBOT/CME/NYMEX -- another thing a more targeted reporting piece could focus on -- there's a potential monopoly -- see their relationship with ELX, etc.), I'm guessing, correctly foresaw that they didn't want to be anywhere near CDSes with the political backlash coming. So they wisely turned down his idea. But I could be wrong there -- have no close familiarity with what really went on.
So that's a little history. I don't know the specifics of the ICE clearing house conspiracy meeting whatever. But there are hundreds of these 'working groups' for new types of derivative products. They're traditionally just large market participants voicing their concerns about how things are going to be traded (the software involved, the types of contracts, etc.). But...it's not a conspiracy.... Not any more than ISO / HTML5 working groups are conspiracies between tech companies to push their interests (I mean there's always going to be a little bit of that). But these are traditionally actually very good things -- people coming together to determine how to trade things in the open.
The problem is Goldman Sachs picking up the phone and creating a custom contract with AIG to insure themselves against a mess of mortgage-backed securities that they got themselves into. The problem is that (a) they could trade these to begin (see THE INSIDE JOB, etc. -- for the rationale behind Glass-Steagall, and the problems with its repeal) and (b) that this didn't happen in a free, open, accountable market and of course (c) that they got bailed out because they were so integral to the financial markets to begin with (which wouldn't happen if part (a) were addressed).
But I mean obviously if you're going to start regulating things more closely, it's good to figure out exactly what to regulate. But I suppose I really should get back to programming...
You make two points in the two posts that are related:
The key point that is missed in all this imprecision -- is that CDS derivatives markets are not like other derivatives markets -- which are regulated. They are contracts that occur between large financial institutions only. That is the 'secret'. The rest is just the equivalent of a high school tourist at the visitor's desk.
Eventually these contracts became standardized -- they referred to the same # of bushels, and they were backed by clearing firms and central clearing houses at the exchange
In the current state of affairs, the CDS market is not transparent and the participants who want to avoid transparency point to the custom nature of the contracts as a reason that they shouldn't be quoted electronically. However, this situation is similar to what existed in equity/index options before the products started to be listed by exchanges: customized contracts were traded through brokers. This sort of OTC trading still occurs, but it exists alongside a very large, very active market of exchange-traded options whose prices are very transparent and thus automatically force down the fees that can be charged in the OTC market because they provide publicly available pricing information on similar contracts. If electronic exchanges were to create standardized contract terms for CDSs targeting some of the more heavily traded debt instruments (sovereign debt be a good target at this point for obvious reasons) and then list these contracts electronically, I suspect that this would bring a great deal of transparency to the pricing of these products due to the participation of firms like Citadel (which already has a large and profitable group making markets in electronically traded options). Large players have resisted such transparency in the fixed income markets for years, and this seems no different.
4) This just represents a simple architectural
programming pattern and should be completely
open and commoditized
While in general the article is true, as always, journalists fudge truth just a bit to sound more sensationalistic.
> But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.
Sure there are fees, but most of the premium is the price of risk, the price of the insurance if you will. While banks sometimes do some proprietary pricing enhancements, the foundation methods are usually the same and can be picked from books (like the bible of derivative pricing by John C. Hull) and papers. I know for a fact that big commodity companies (e.g. oil companies) have their own financial analysts on staff to double check derivative pricing. And it is not just that this allows you to haggle with the banks - you do no want to get derivatives that are too cheap either. That may be a result of incompetence or a sign of trouble - should the derivative seller pay to you they will not have enough capital to cover their obligations. That is exactly what happened with AIG and Lehman Brothers.
Now, Robison Oil may not be that big to have financial analysts on staff, but they could use third-party pricing consultants, at least.
And yes, that lets the risks pile up too.
And no, I don't think the bailout left us better off but the fix was in long before October 2008.
That doesn't mean we can start unwinding things by rolling back the individual policies that are causing the risky behaviors.
The government could, for example, ensuring only 80% of their bank deposits. We could start phasing out subsidies for housing by 2% per year. We could let the market set interest rates.
Of course, the people in charge (regardless of which party) seem to think only more government interference in the economy could possibly help. They seem incapable of examining anything they've done or admitting any errors.
Though one should also look at the number and sophistication of the people a company deals-with, the amount of leverage it uses and so-forth. But this kind of analysis isn't really new. It is what central banks are supposed to do. The Fed's job was "to take away the punch bowl just as the party gets going," (http://en.wikipedia.org/wiki/William_McChesney_Martin,_Jr.). Unfortunately, the Fed joined party itself with the repeal of the Glass-Steagel act and we've had stimulus-through-speculation over the last twenty years. The rise of speculative excess has a societal and psychological dynamic and once it gets going it is sustained by the social power achieved by the speculators. The pattern is old and has ended in grief a number of earlier times in history.
I would recommend http://prudentbear.com/ and Doug Noland's Credit Bubble Bulletin. This gives an intelligent analysis of the last twenty years' speculative excesses.
Also, before tossing out knee-jerk anti-regulation comments, consider how well Alan Greenspan used this sort of ideology as "covering fire" for the speculator economy. I'm neutral on whether a libertarian system could be built soundly from the ground up. But I think it's crucial to note how the use of a bit libertarian rhetoric to dodge regulations when convenient has been instrumental in leading us to the unsound ground we are currently on. (I would admit that Ron Paul's critiques Greenspan's policy actually have been quite good over the years).
The idea that there is some central intelligence that can decide the soundness of investments deceives the average investor or saver into thinking they need do nothing themselves. All the while the government is actively making things less sustainable and handing out favors along the way.
One could argue that the same is true of private stamps of approval. But there is competition and many voices out there, each having their own tolerance for risk.
To have government regulating things is like your brain never having doubts, never weighing competing concerns except for political ones. And many people think that way, just going along with the crowd. But we can't afford to have that sort of thinking govern everything.
But I would just as much note that most people shouldn't have more than a fairly small percentage of their savings in real, honest-to-god risky investment. The small investor's chances of being wiped-out are too high and their being wiped out would, again, have a cost to society not just themselves.
Thus, the government should supervise a system where most of the average person's savings go into simple, plodding savings accounts and a fairly small amount is invested.
This system worked pretty well 1933 ~ 1980. I think Nicholas Taleb also mentions a similar system.
Oddly enough, a lot of this comes down to the non-Gaussian nature of a market's expected return. The theoretical foundation of all the schemes for interdependent, self-insured investment processes assumes the distribution of market corrections was Gaussian and that thus large corrections would be rare and multiple investment vehicles would support each other through the law of large numbers. But with a non-Gaussian, "L-stable" distribution, you simply can't expect such things.
Government aren't always. Certainly the US government has become more corrupt on the level of policy over the last thirty years but private industry has become similarly corrupt (as well as entwined with the state). I'm not sure what to do here. The state creates monopolies and then
Mandlebrot's essays on finance are very important to look at (along with Hyman Minsky's theories, etc).
But considering we live in a complex, interdependent society, I'm skeptical that risk is going to be decoupled any time soon. I actually think regulating the most risky behavior is more practical than arranging for each person's risky behavior to only affects them.
Long term its a game we can't win and it will collapse. And that collapse may ruin the US's ability to compete in the world, letting others win the next technology battle and leave us subject to their whims.
The whole mess can keep going, but ultimately it must compete with less stupid societies.
Bottom line is anyone that acts surprised by the lack of regulation shouldn't be because Congress voted on and passed a law specifically prohibiting regulation of derivatives in the 90's. A law that was promoted by the same people who now run all the US government agencies like CFTC, Treasury etc...
I can't even say any more than that about the article - it would be like when my Mom tries to talk about programming. I just thought I'd drop a little plug for the film here (no affiliation) in case anyone else wanted an interesting and easy starting point for this stuff :)
That said, you can probably learn a decent amount by reading a book called "Hedgehogging.". It goes into some of the cultural aspects of finance.
Just keep in mind that "trading" is all about having a better eye for value than the other guy. In every respect. If you're bad, you'll get fleeced. And by you, I mean everyone who has placed money with you.
Thanks for the recommendation - I will be buying Hedgehogging this week if I can't find it at the library.
Like most things, different perspectives led different people to arrive at different conclusions about what led to the crisis.
Put very simply, the folks in charge (traders) were simply allowed to take on too much risk. And by risk, I mean that they were allowed to borrow money to make bets on the future value of securities. They believed that most of that risk was offloaded to a company that could absorb it (AIG) but it turns out that they couldn't. When everyone found out that AIG couldn't absorb that risk (defaults on mortgage-backed securities), they ran for the hills (refused to lend money with mortgage-backed securities as collateral).
Hedgehogging will give you a good idea of the people/mentality that drives traders and how managing big money works. It's a complicated business and quite different from your regular mom-and-pop investor. One of the lessons I took from the book was that being very successful in your fund can lead people to WITHDRAW their money from your account. It's like they expect you to be unable to repeat your performance.
Another lesson is that a lot of hedge funds fail. Their fund manager can't get out of a slump and everyone takes their money out. The fund closes.
But the best lesson is the analogy of fund managers to star athletes. Those managers that can consistently beat the market are paid very well because they are making a lot of other people very very rich. That's rare and not a lot of people can manage it.
Imagine some techie eating lunch with his techie buddies. Is he likely to talk about how he's against net-neutrality, or is it likely that he's for it? If he were against it, he'd seem weird.
Basically, you're not going to screw the people you hang out with all the time, and might want to work with later.