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Sunday, March 14, 2010

Barry Ritholz gives the short course in derivatives

Complexity is too often the smokescreen behind which the status quo hides. "It is too complex," therefore nothing should be done that is too radical. This is simply stalling as the or the complex fire burns down your house. Derivatives are a case in point. One can weave tapestries of immense precision using the threads available in the hypothetical world of market efficiency. But when the evidence of AIG and the immense exposure are all too evident, it is time to return to the real world and put the fire out -- if it is not too late.
Time to Regulate Derivatives (like every other financial instrument)
from by Barry Ritholtz
The Big Picture
March x, 2010

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.


  1. I can see the banks objecting to this as strongly as possible. If they had to maintain reserves and capital to trade derivatives then it would eliminate their ability to over leverage and it would mean that the banks would have to substantially reduce exposure to derivatives. I would add that standardised derivatives would also make it easier for all concerned to assess the risks. Overall the trade would be as you mention, far less profitable for the banks, but the risks for the tax payer also considerably lower.

  2. These derivatives are the latest in a series of innovations to enable increased leverage. All innovations, from commercial paper to MBS's have eventually been backstopped by the Fed. The crunch that is yet to fall is the (inevitable) call to backstop the CDS's. AIG is only the beginning.

    Here's some reading from Hyman Minsky, now a quarter century old. The fact that we are still short of "effective controls on bank risk exposure" demonstrates we are far short of a stable financial system. [from Stabilizing an Unstable Economy]

    "... fortune seeking by the managers of institutionalized enterprises leads to an emphasis upon growth, which in turn leads to efforts to increase leverage. But increased leverage by banks and ordinary firms decreases margins of safety and thus increases the potential for instability of the economy." [p.266]

    "The presumption is that the protection from the regulatory authorities makes private surveillance unnecessary." [p. 267]

    "In the absence of effective controls on bank risk exposure, bankers' efforts to increase their profit growth by increasing their leverage will lead, from time to time, to wholesale cash flow difficulties. As a result ... bailouts. Such bailouts, which are necessary to prevent deep depressions, serve to validate financial practices that contributed both to debt burdens ... and the exposed positions of the banks." [p. 269]