What is it about derivatives that makes otherwise rational humans become so damned stupid? There is no need to over-complicate this; a rather simple series of steps can be undertaken to bring the most dangerous of derivatives out of the shadows and into light of day.
Radical derivative deregulation had a bastard birth: On the eve of a holiday break, Texas Senator Phil Graham attached a budget bill rider titled the Commodity Futures Modernization Act of 2000. This was done at the behest of his wife Wendy, who was a member of the Board of Directors of Enron.
What the CFMA did was create a unique financial product. Derivatives and Swaps entered a world where they were treated very differently from all other financial products. Stocks, bonds, options, futures all follow specific rules. Securitized derivative products (collaterallized paper such as CDOs, CMOs, CLOs, etc.) and Credit Default Swaps (CDSs) do not.
Consider for example these characteristics of most financial instruments:
-They trade on an exchange; -Participants have sufficient capital to engage in trading; -Counter-parties disclosure is known (at the least to the exchange) -Potential future payments require capital reserves to meet obligations; -The full amount of traded instruments is transparently disclosed; -There is a regulator in charge of insuring the above rules are followed.
Derivatives had none of those. Indeed, the CFMA specifically exempted derivatives not only from these items, but added they were exempt from state insurance regulators.
Let’s not over-complicate this: We need to do 3 things to rein in the worst aspects of derivatives, and dramatically reduce the systemic risk they present, while retaining their ability to be a valid financial instrument for hedging risk:
1. Repeal the Commodity Futures Act of 2000
2. Treat Derivatives like all other financial instruments: All of the above elements need to be derivative requirements;
3. Give the Commodity Futures Trading Commission full oversight and the teeth to enforce the rules.
Wall Street and the banks will fight this tooth and nail, as they are reaping billions in derivative trading profits. Never mind that whole 2008-09 meltdown thingie — that’s ancient history.
This is simple, folks: Derivatives should not receive special treatment — they need to be regulated the way most other financial products in the world are.
>
See also: Goldman Deal-Maker Now Advocates Regulation GRAHAM BOWLEY NYT, March 10, 2010
http://www.nytimes.com/2010/03/11/business/11cftc.html
lets not forget to terminate offsetting trades! as an “old” option trader, how would that look if all the trades stayed open? counterparty risk? a long, long row of dominos? as usual our esteemed government & legislators snuggle up to the wards of wall street and pretend not to see the elephant in the room.
Consider for example these characteristics of most financial instruments:
-They trade on an exchange; -Participants have sufficient capital to engage in trading; -Counter-parties disclosure is known (at the least to the exchange) -Potential future payments require capital reserves to meet obligations; -The full amount of traded instruments is transparently disclosed; -There is a regulator in charge of insuring the above rules are followed.
Derivatives had none of those. ~~ if “Derivatives” had those features, one wouldn’t have been able to, so artfully, rig the Building–for it’s controlled demolition.
Economy Ramp n’ Crash2.0
“But regulation means government, and government reminds me of how we had to desegregate our schools, so I’m against it.” — The GOP.
Do you mean regulate in the same way the SEC regulates naked short selling and insider trading – like not at all ?
Seriously though this type of article stinks of ignorance
The bulk of derivative transactions are futures and options which are already exchange traded.
The OTC market has evolved to satisfy the needs of customers because of the lack of flexibility of exchange traded products. Customers want to hedge their risks exactly, not trade something similar that creates more risks than it hedges.
The OTC interest rate derivative market copes with major events (such as Lehmans) without a hiccup – I notice you dont mention the details of ISDA documentation in your rant and how netting of off-setting risk happens automatically in the event of default. There is no real need to offset trades as it is effectively done legally anyway.
You also forgot to mention how the majority of OTC trades are now being cleared – read margined allready.
The market has already changed – the last thing needed is more pointless government regulation. AIG and others got into trouble because they didnt understand what they were doing and were running excessive leverage. Derivatives in general were in no way at fault. If you want to blame unmargined CDS trading then I agree – but that is a small subset of the derivatives landscape.
SB
It should have been clear to you from the reference to Options and Futures (above) that they were already covered by extensive regulation.
What I was referring to are securitized (primarily collaterallized) derivatives such as CDOs, CMOs, along with Credit Default Swaps (CDSs). (I will clarify that above for the reading comprehension impaired)
As to your suggestion that we should leave well enough alone, well, its an absurdity. Your may be protecting your own profits, but you are doing so at taxpayer expense. That is unacceptable to me.
Steven,
you should have stopped before you got to: “AIG and others got into trouble because they didnt understand what they were doing..”
before then, you had a nice defense of OTC Deriv.s going..
For once I agree with MEH. In addition the hedge their risks exactly line is analogous to we have to pay these losers huge bonuses to keep them rationale.
Steven,
“You also forgot to mention how the majority of OTC trades are now being cleared "“ read margined allready”
Factually incorrect probably by a factor of 10X.
Also, OTC derivatives have “super-senior status” They get paid even before any bond holders in the US.
As of 2nd of March LCH.Clearnet (one of a number of otc derivative clearers) now clear $212 trillion of Interest Rate Swaps. This is anew process and growing quickly.
Last available figures are Jun 2009: Total derivatives outstanding 604 trillion of which 49 trillion is fx based, 437 trillion is interest rate based (of which 341 are IRS) and 36 is CDS.
How exactly am I out by a factor of 10 ?
~~~
As to super senior status – no
ISDA documentation means that at a global counterparty to global counterparty level all transactions dealt under the ISDA master agreement are marked to market, cash flows are netted and the deals are cancelled. Residual amounts are treated as any unsecured creditor. MOst important is that receivers are unable to cherrypick and perhaps that is where you get the idea of super senior status.
The first major counterparty default I dealt with was Drexells – it all worked perfectly even then with no market ripples on the derivative side. SInce then the derivative market has gone through numerous counterparty events.
Unmargined CDS are the exception due to the fact that the ‘notional’ principal isnt really a notional amount but is in fact the amount of risk.
great king rat: Is our children learning?
“The market has already changed "“ the last thing needed is more pointless government regulation. AIG and others got into trouble because they didnt understand what they were doing and were running excessive leverage. ”
Ha ha ha ha. Yeah, and look how well deregulating a handful of financial institutions regarding leverage worked out. And the tax payers should keep ponying up to these blackmailers while they learn the ropes of raking it in, too. Jokes on you, Americans.
Read Full Article »