Toward Transparent Derivatives Trading
posted by Frank Pasquale
Could you describe the financial crisis in a sentence? Margaret Atwood’s description (in Payback: Debt and the Shadow Side of Wealth) appears to me as good as any:
[This] scheme. . . boils down to the fact that some large financial institutions peddled mortgages to people who could not possibly pay the monthly rates and then put this snake-oil debt into cardboard boxes with impressive labels on them and sold them to institutions and hedge funds that thought they were worth something.
I’d only add one amendment, to recognize the last step in the agency problem: the products were sold by and to institutions whose managers believed that they could still pocket fees and bonuses without being liable to principals for gross malfeasance. As the former head of AIGFP enjoys his fortune, the joy in passing on the proverbial hot potato must daily bring a smile to his face.
As these black boxes continue to blow up, the WSJ Opinion page recently featured a proposal to open up some of them. Professors Viral Acharya and Robert Engle argue that “derivative trades should all be transparent,” in refreshingly plain English:
Most financial contracts are arrangements between two parties to deliver goods or cash in amounts and at times that depend upon uncertain future events. By their nature, they entail risk, but one kind of risk — “counterparty risk” — can be difficult to evaluate, because the information needed to evaluate it is generally not public. Put simply, a party to a financial contract might sign a second, similar financial contract with someone else — increasing the risk that it may be unable to meet its obligations on the first contract. So the actual risk on one deal depends on what other deals are being done. But in over-the-counter (OTC) markets — in which parties trade privately with each other rather than through a centralized exchange — it is not at all transparent what other deals are being done.
This makes it likely that some institutions will build up excessively large positions in OTC derivatives without the full knowledge of other market participants. If these institutions were to default, their counterparties would also incur significant losses, creating a systemic risk.
Acharya and Engle criticize Treasury Secretary Timothy Geithner’s proposed new regulations on derivatives trading for not going far enough to address these issues. I’m not surprised at their inadequacy, but I think Acharya and Engle may underestimate the growth of secrecy as a linchpin of contemporary capitalism. Trade secrecy is a key part of the business practices of all manner of middlemen, ranging from search engines to health insurers. We can debate its utility in those fields. But it appears totally out of place where a Gordian knot of gambles can put the entire global financial system at risk. Trade secrecy has little or no place in a financial world wrecked on the shoals of black box derivatives trades and an opaque “shadow banking system.” As Stephen Mihm has noted,
The drumbeat of bad news . . . is [according to many experts] only a symptom of something new and unsettling – a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools. That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade – a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.
Even if the Acharya and Engle proposal is deemed too extreme by team Geithner/Summers, it would be inexcusable not to have some group within the SEC given this information in real time. Think of it as a FISA court for finance.
May 17, 2009 at 6:21 pm
Posted in: Corporate Finance, Economic Analysis of Law, Uncategorized
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Responses (4)
A.J. Sutter - May 17, 2009 at 6:49 pm
I’m a little confused as to what should be transparent. Maybe I’m thrown by Acharya & Engle’s phrase “actual risk” — what does this mean?
Is a plain vanilla insurance contract transparent about “actual risk”? Yes (kind of, aside from lawyerly gobbledygook), if that phrase means describing what insurer must pay to insured, and under what conditions precedent. But no, if that means disclosing what are the odds that insurer will have to pay.
It sounds like A&E are talking about transparency of risk in that second sense, though. And here there is a deeper problem than just trade secrecy: it’s that expectation values — which are obtained from mutiplying the magnitude of a payoff by the probability of the payoff occurring — are not reality. Transparency of the parties’ models isn’t transparency of “actual risk”. It’s simply transparency about parties’ expectations, which may be delusory.
Maybe the problem is that “transparency” and “actual risk” suggest that risks can be accurately quantified, calculated and written down. So how about a change of pardigm, away from the visual, “transparency” metaphor and more towards an olfactory one? Derivatives disclosures might not enable determination of “actual risk,” but in the aggregate they could alert regulators or the public that the whole mess stinks.
Frank Pasquale - May 17, 2009 at 7:04 pm
I’ve thought a bit about these ideas in the context of health insurance, AJ. For example, if a doctor agrees to see all of his patients any time, is he effectively an insurer, an “entity bearing risk”? It seems very unlikely that more than a few people will get sick at once–but it also seems reckless for him not to at least make some contingency plans.
As for difficulty of calculating expectation values, it seems to me that the proposal here is designed to smoke out the worst offenders (like AIG). That is a “smell test” model, which reminds me of this reflection on “sight vs. the other senses:” “how has the metaphor of vision for knowledge colored our conceptions of knowledge”?
anonprof - May 18, 2009 at 3:04 am
Frank–Thanks for the Atwood quote–it may be the best one on the crisis yet.
Nate Oman - May 18, 2009 at 7:29 am
It seems to me that one of the biggest problems with counter-party risk is that in theory these risks were supposed to be disclosed in regular financial statements where the CDSs were to be carried as liabilities. The problem is that this gave to the accountants the insurmountable task of valuing liabilities in an opaque market. Just having people report their CDS contracts to the SEC in real time wouldn’t make that big of a difference. It seems to me that what we need is a thick and relatively commoditized market in these contracts, so that we can use the market to value the risk rather than kidding ourselves into believing that through some heroic act of calculation the accountants and actuaries can do it for us. At the end of the day, it seems to me that CDS contracts are very much like commodity futures. The best solution is to set up clearinghouses that deal in standard forms and start generating thick, transparent markets to value the CDSs, rather than relying on accountants or (worse yet) regulators.
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