Solution: Derivatives On Exchanges

Sunday, June 07, 2009

Richard Bookstaber, an authority on derivative trading, testified before a Congressional Committee in a hearing entitled Regulatory Reform and the Derivatives Market on June 4, 2009. Bookstaber has spent years in risk management at various institutions including Morgan Stanley, Solomon Brothers, Citigroup, Ziff Brothers Investments and Bridgewater Associates. He has also authored several books on the subject of derivatives, most notably A Demon of Our Own Design published in April of 2007 that warned of the possibility of a financial crisis arising from our abuse of derivative products. His testimony was both straightforward and enlightening.

Bookstaber begins his testimony by asserting the benefits from the development of derivatives. Derivatives allow market participates to tailor products to their specific needs. Institutions can use various products to create more perfect hedging instruments and to execute more precisely their potentially profitable ideas in financial markets. Yet, as derivatives grew over time and regulation failed to keep up, all kinds of products were generated to pursue the goals of institutions and individuals. Many of these goals were, as Bookstaber argues, to game the system.

As time progressed, however, derivatives found use for less lofty purposes. Derivatives have been used to solve various non-economic problems, basically helping institutions game the system in order to:
  • Avoid taxes. For example, investors use total return swaps to take positions in UK stocks in order to avoid transactions taxes.
  • Take exposures that are not permitted in a particular investment charter. For example, index amortizing swaps were used by insurance companies to take mortgage risk.
  • Speculate. For example, the main use of credit default swaps is to allow traders to take short positions on corporate bonds and place bets on the failure of a company.
  • Hide risk-taking activity. For example, derivatives provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored. Derivatives also can be used to structure complex risk-return tradeoffs that are difficult to dissect. These non-economic objectives are best accomplished by designing derivatives that are complex and opaque, so that the gaming of the system is not readily apparent.
Similar to what Nassim Nicholas Taleb argues in his April interview on Bloomberg, derivatives allow the system to have too much hidden risk. The massive exposure to structured products at banks around the world led to rapid deteriorations in the balance sheets of many of the largest financial companies as the US real estate market slowed. Credit default swaps at American International Group allowed the company to collect small premiums while risking bankruptcy should spreads widen significantly. AIG was essentially selling insurance, yet, was unregulated in that portion of its portfolio. And, given mark-to-market rules in securities, AIG was forced to writedown billions in assets even though it was not required to actually pay out on the contracts.

Many derivative products are hitting mainstream in the form of exchange-traded funds. Individual investors are now able to bet on declining prices while entering a long position in an ETF. Many of these products are highly opaque with individual investors lacking an understanding of the return calculations. As The Market Guardian demonstrates in a piece entitled "A (Popular) ETF Down 97% (FAZ)", investors have lost billions yet continue to commit capital to the three-times ultrashort financial ETF created by Direxion. The FAZ "attracted the second-greatest inflow of any ETF on the market, at $4.6 billion ... Despite the massive inflows, FAZ ended May with just $1.6 billion in assets. Such a gap suggests that investors in the fund have experienced terrible returns." Even the more simplistic products structured as ETFs are difficult for the average investor to understand potential risks.

Jim Cramer has railed against the huge growth in ultrashort funds that were a favorite of short-term traders throughout 2008. The "skiffs", as many on the trading floors across Wall Street call them, are shares in the ProShares Ultrashort Financials, traded under the symbol SKF. Trading in these products, while seemingly innocent, does in fact influence the actual stock prices of the included financial companies. Cramer hammered away on his nightly show that the skiffs were destroying financial equities as traders created and rode the momentum for the destruction of several large banks. Bookstaber agrees that trading in derivative products has many indirect consequences unseen by the public eye.
There are a number of ways the swaps and derivatives end up affecting the market:
  • Those who create these products need to hedge in the market, so their creation leads to a direct affect on the market underlying the derivative.
  • Those who buy these instruments have other market exposures, so that if they are adversely affected by the swaps or derivatives, they might be forced to liquidate other positions, thereby transmitting a dislocation from one market into another.
  • The market price of some derivatives can have real effects for a company. For example, the credit default swaps are used as the basis for triggering debt covenants, so if the swap spread for a company’s debt rises above a critical level, it can have an adverse effect on the company. Indeed, a dislocation in the credit default swap market can have a more immediate and severe effect on a company than will a dislocation in its stock price, because the credit default swap spread has an impact on the ability of the company to obtain financing.
  • Derivatives can change the behavior of the market. For example, when various bonds are packaged into Collateralized Debt Obligations, they become linked in a way that they might not be absent this packaging. As a result, the diversification potential within the market can be lower and the potential for contagion between market segments can increase.
  • Those who are writing OTC derivatives are in effect providing insurance to the buyers, but without any regulatory requirements on minimum capital. Those writing these instruments may not be in a well-capitalized position to pay out in the event that the option goes into the money.
In effect, Bookstaber argues that derivatives can have effects far beyond the profit or loss to the individual that takes the bet. Derivatives change markets for better and worse because the institutions taking the other side of the product typically hedge that exposure in some way. Or, if not, and the position creates losses for the institution, it may liquidate other holdings. Movements in the CDS market have even begun to affect the credit ratings of companies as spreads are a direct indication of market belief. Institutions are even able to participate in highly regulated businesses via the CDS market without the regulation. In the case of AIG, the company avoided regulation by writing thousands of CDS contracts that eventually brought down the company.

Derivatives have allowed for companies to hide risks by creating very complicated risk-to-reward payoffs. As Taleb points out in Fooled By Randomness, in his classical turkey analogy, blow ups often occur often with companies that have been gliding along, raking in profits in the short-term while taking massive risks in the long-term. The complex payoffs in many derivative products allow a company to collect short-term premiums for years until the "hundred-year flood" occurs and the company collapses overnight.

All these problems give credence to Bookstaber's call for increased regulation and centralization of products on an exchange. Requiring institutions to trade derivatives on exchanges will create standardization of products and increase transparency to investors and outside counterparties. As Taleb pleads in his "Ten Principles For a Black-Swan-Proof World", "Do not give children sticks of dynamite, even if they come with a warning." Very few understand many of the products they are trading and we need to ban them. If no one understands the product, and as we have learned they can impact the entire system, it makes sense to stop creating them.

The problem is that the private sector will almost certainly be resistant to centralizing all trading on exchanges. The built-in incentives for all involved is opacity. The greater the opacity the greater the possibility for manipulation and hidden risk-taking. Complex derivative products allow managers to do what they cannot under current regulation and law. Bookstaber lays out the incentive structure in his testimony.

For the bank, the more complex and custom-made the instrument, the greater the chance the bank can price in a profit, for the simple reason that investors will not be able to readily determine its fair value. And if the bank creates a customized product, then it can also charge a higher spread when an investor comes back to trade out of the product. For the trader, the more complex the instrument, the more leeway he has in his operation, because it will be harder for the bank to measure his risk and price his book. And for the buyer, the more complex the instrument, the easier it is to obfuscate everything from the risk and leverage of their positions to the non-economic objectives they might have in mind.
In the end the need for trading to take place on an exchange seems clear. Even just the CDS market, with size estimates upwards of $50 trillion, the affects of major dislocations can be devastating to the entire global financial system. As we have found with many financial markets, the greatest efficiency is achieved by increasing transparency. The derivatives market is far too opaque. The current market allowed one company, the now-nationalized AIG, the ability to collapse the entire global system by writing an absurd number of CDS contracts. The US government was forced to nationalize the company or allow the market to meltdown as AIG would be forced to renege on its insurance guarantees and would create panic between banking institutions. Change is needed and exchange-based trading seems to be the most logical change even if industry fights it.


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