Avoiding the Tail Wagging the Dog

I’ve written a number of pieces where I have discussed limits on derivatives.? These have seemingly been among my least popular pieces, partly because I seem to argue against the free market.? I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis.? This piece is meant to integrate my thoughts on:

  • Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
  • Insurable interest with respect to credit default swaps [CDS].? Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
  • Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability.? Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging.? The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more.? Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators.? Every transaction must have a hedger.

One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets.? This will keep “the tail from wagging the dog.”? After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary?? Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies.

My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy.? Now, some will say,”Doesn’t all investment involve gambling?”? My answer is no.? All investment involves risk-taking, but there is a difference between risk-taking and gambling.

Every business/businessman takes risks.? Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets.? The prices of the shares and bonds reflect marginal perceived risk of the business.? That risk is necessary risk.? Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.

Most people buying/shorting a stock have some reason why they think they will make money.? Even if they are wrong, they don’t think their actions are as uncertain as a coin flip.? Few pick tickers randomly, and decide positions (buy/short) randomly.

My third core reason is to reduce regulatory and taxation arbitrage.? Many derivative transactions are done to escape regulations and taxation existing in the underlying markets.? Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.

There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset.? But on the whole, speculative markets should not exceed the demand for hedging.? Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed.

That’s my position.? Separate investment and gambling through a requirement of hedging in synthetic transactions.? If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.

I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term.? Gambling, even if legal,? never has moral legitimacy.? Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.

16 thoughts on “Avoiding the Tail Wagging the Dog

  1. This makes way too much sense to ever be adopted.

    If the people who ran Wall Street were long-term greedy, you might have a chance–but these days they are short-term greedy (for a whole bunch of reasons, some justifiable, some not.)

  2. I’m not sure I agree with you, however, this is an interesting perspective to take, and one well worth consideration.

  3. your explanation between risk taking and gambling is one of your better insights David. Too bad the regulators and Congress will not read this article.

  4. You have not taken into account the legitimate need of Wall Street firms to have trading profits and consequently obscene bonuses. Entire industries (private-jet manufacturing, yacht building, Swiss watch makers etc.) could be bankrupted by this hare-brained proposal (not to mention choking off funds to needy Congressmen and Senators).

  5. You have some measured thoughts but i disagree with you. Your argument is based on the premise that derivatives are bad and caused the financial crisis. It’s also based on the ability to regulate these markets.

    I don’t think derivatives specifically cds are bad. Investors did poor analysis when evaluating counterparty risk in their derivative positions. For instance, goldman did not properly evaluate the counterparty risk of buying protection from aig. Blame goldman, don’t blame the instrument.

    One positive that i think gets overlooked is that cds creates a single tradable instrument that reflects the credit risk of a particular counterparty. When a GE capital has 300 different bonds outstanding, having a single instrument is efficient. it allows the markets to quickly reflect credit spread. It creates liquidity, allows lenders to quickly assess appropriate credit spreads and ultimately allows borrowers to borrow more cheaply.

    There are innumerable ways to take credit risk. CDS is one of them. Ban them, regulate them, another form of credit risk will develop. I also think gray/black markets will pop up outside highly regulated markets. ie, derivatives markets will start to trade outside the u.s. on u.s. names and outside the purvey of u.s. regulators.

    I would love to see cds on exchanges, transparent pricing and standardized contracts, but i think the market will make that happen over time. it takes time for organic systems to develop. Government involvement may accelerate (or slow) that process. But free markets are still the best at creating these systems.

    You criticize the size of the market. There’s a buyer and a seller in any cds contract. This definitely increases the notional. But i don’t know that that’s bad. Netting positions in the street should be done more often but again i think the market should dictate that not regulators. I think the size of the market reflects enhanced liquidity and is a good thing.

    Restrict trading in these instruments and you will lower liquidity and ultimately raise borrowing rates thus slowing an economy.

    I respect your opinion, but I do believe in the free market and I think this crisis leads me to believe that regulation and government involvement leads to volatility and promotes bubbles, doesn’t suppress them.

    The best regulator is the market. When AIG goes belly up, goldman should pay the price for poor credit underwriting. That would rationalize wall street.

  6. David, while I agree with you 100% that too much speculation is just gambling (not risk taking) — a certain (albeit much smaller than present) amount of “pure” speculation provides price discovery that benefits the hedgers and society as a whole.

    Less speculation would be a great thing. Zero speculation would actually hurt the markets

    Second, I am not sure your suggestion would be practical to implement. I spent many years working at a sell side shops — and all of them co-mingled their proprietary trading (speculating) with their market making (hedging). All the trades cleared on the exchanged in a single firm account (or maybe by product). There was no way for the in-house accountants, much less the exchange or regulators, to know what trades were hedges and which were speculation.

    Further, any large institution is going to have significant netting across traders and across desks. And in quite a few instances, there was netting between two books managed by the same trader (hedging different risks and/or speculating on different themes).

    Lastly, your idea could increase costs for hedging in many cases. If your insurance company needs to do a rate lock (just as example) on $1 billion — its usually cheaper to do one big lock than 10 locks of $100 million. Right now, the sell side firm nets your lock against all the other risk on the desk, and hedges only the residual risk. If you separate hedging and speculating — then the entire risk would have to be hedged separately (probably at a higher cost to reflect higher liquidity risk)

  7. Thank you, sir. I will happily read more of your posts on this matter.

    I just wrote a 40 page paper saying exactly the same thing. Shoot me an email if you would like to read it. So, there’s my bias disclosed.

    One thing I have noticed time and time again for the proponents of naked CDS is that they never discuss what happens when the counterparty CANNOT pay. Aaron Unterman, a law professor, pointed out that this credit crisis was really a counterparty crisis, i.e., everything is hunky-dory until A.I.G. couldn’t pay up. If the counterparty cannot pay, netting does not eliminate CDS risk. If all naked CDS are private contracts, even if counter parties net on one contract, neither one knows what contracts the other holds with other counterparties. And since naked CDS are freely assignable, not even the counterparties know who they are transacting with half the time. And no one is required to keep enough capital reserves to pay these contracts. Hedge funds fold; banks go to the government with their hats in hand. If you want to gamble, fine; just don’t come to the government demanding taxpayer restitution for your crummy bets.

    Not even bankruptcy will protect a counterparty – naked CDS are under a safe harbor provision, allowing a counterparty to loot the bankrupt counterparty. If you want to gamble, fine, but don’t come whining to the court system to enforce your crummy bets.

  8. I think that you denigrate casinos in your last sentence. Most casinos are highly regulated. In return for the right to stack the odds slightly in their favor, the casinos agree to have rules and to hold a substantial margin of cash in order to pay off bets on the floor.

    If the CDS markets had been run like casinos, we probably wouldn’t have had the meltdown of AIG etc.

    As they were effectively pretending to be the house, AIG would have needed significant cash on hand as collateral for their CDS’s. Instead, they ended up playing the role of the underfunded patsy trying to win by playing all of the roulette wheels at once. As a result, the taxpayer was asked to step in and bail them out as well as all of the other gamblers on the floor instead of having the security guard detain them.

    In the end, all we need to do is ask the markets to become at least as well regulated as a Nevada or New Jersey casino.

  9. I’ve worked in asset management for a significant period of time and have been involved in agreeing derivatives trading terms between ourselves (the investment adviser for a number of mutual fund accounts) and Wall Street counterparties. We generally given a choice of pitting place either clauses to allow for counterparties to call for collateral (collateral management is hard) or to allow mark-to-market settlement calls (much easier). A mark-to-market settlement call allows a Street counterparty to call for settlement of their net outstanding MTM profits (fund’s outstanding loss MTM lossses) exceeded a certain percentage of the fund’s daily-calculated Net Asset Value and vice versa the fund could do the same.

    Once the outstanding MTM was settled the existing contracts were torn up and replaced with new contracts issued at the price that was used as the valuation mark in the MTM settlement.

    What *I* don’t understand is why AIG seemingly wasn’t required to put up collateral or subjected to similar marking-to-market requirements by Goldman. Or if they were, why these failed to alleviate the situation.

    As a sidenote, from memory I think Goldman had the laxest credit rating limit on what they regarded as acceptable collateral of any of the houses we dealt with. Goldman should have been allowed to fail.

  10. Greg is absolutely correct in my opinion – not allowing netting of risk within institutions is massively inefficient. ‘k’ (poster number 6) also makes an excellent point in advocating a move from over-the-counter trading to trading in exchange-traded contracts, both from a liquidity and efficient price discovery perspective AND from the perspective of counterparty risk management since exchanges require collateral (“initial margin”) equal to their estimate of teh worst likely net one-day loss) with daily marking-to-market (“variation margin”).

  11. Completely agree on the need for derivatives regulation. As for relative legitimacy compared to the casinos, last year I would have agreed with you, but in Las Vegas you generally get a fair deal. I’m not sure given what’s come out about high speed trading and the dark pools you can say the same for Wall Street.

  12. I tend to take people to task for suggesting insurable interest in derivatives, as speculators play a valuable role in hedging activities.

    But, I like the idea of “Only hedgers can initiate transactions.” With that kind of policy, I’m on board with the insurable interest plan. You make a good point that it will limit derivatives markets to a size that reflects the markets in underlying assets.

  13. A buyer of CDS protection for the means of increasing leverage should be required to obtain proof the writer has the assets to cover. This should chain all the way.

    Without it, the CDS contract should be declared invalid because it does not address the 3rd party. The 3rd party being John Q, who ends up eating it.

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