Today’s Regress is Tomorrow’s Progres

Markets move in all directions if you live long enough.  Through the bull runs savvy investors who previously bought on fear finally sell into greed.  And those cyclical tail-end greedy goers usually end up on the sidelines for the next cycle or two, or so I’ve learned.

In the interim, Wall Street concocts new products and/or new structures to entice a new generation of investors, traders and speculators, and to entice older generations, who have long since licked their wounds, to try something new.

Through these cyclical shifts, rules are rewritten, laws are rewritten, and regulations are rewritten.  This cycle will prove no different than those in the past.  In this one however, there has been so much financial innovation over the last 30 years, that there is likely to be, and probably regrettably, an equal and opposite amount of push back into the structure of the our current system.  The details are unknown, but the outcome will be the same.  A once opaque illiquid market will turn retail, enticing the next generation, and luring former casualties (probably from the ’87 crash this time) back into the market.  Simultaneously, the real adventure seekers, and next big-bonus people will be concocting new opaque ways to disguise wide margins on Wall Street.

This is the game that drives our financial system.  It can never change because it wouldn’t work any other way.  Without the lure of profits, innovation is stifled.  While the dot-com catastrophe left craters as scars, it also helped catalyze the single greatest achievement in the field of communications in the history of mankind.  We now have an infrastructure to synthesize, publish and share information in profound contrast to the years prior to 1995.

What will be the benefit of the fallout of this financial meltdown?  Its still uncertain, but reading this article from Bloomberg on the future of a central clearinghouse for OTC derivatives might actually end up achieving what the products were originally intended to do, reducing systemic risks in the system by allowing risk to be priced fairly at the market.

Derivatives are simply a bet on the performance of some underlying instrument.  A credit derivative is a contract betting on the movement of  a credit instrument or a bond.  An equity derivative is similar in that it is a contract on an underlying equity instrument often times a stock or a commodity.

The pricing mechanism for derivatives however is driven less by pure fundamental valuation of cash flows, but rather by a combination of values not the least of which is volatility.  Volatility in turn is a measure of risk.  Thus part of the pricing mechanism of a derivative is linked to the risk of the underlying asset. This allows investors the ability to buy or sell risk from their portfolio.  For some people reading this quick summary the immediate response is, duh.

However given what we’ve been going through, and using “financial weapons of mass destruction” as the trite summary of one of the more popular views of derivatives today, it is important that we realize that like the bubble, it may not be the derivatives themselves (dot coms) that are the problem but quite possible how they have been valued in the market (dot coms were widely valued on click-throughs or numbers of impressions “eyeballs” and rarely on revenues or cash flows).

The majority of the derivatives that today’s retail investors are exposed to are actually exchange traded contracts, with the exception of structured products that package OTC derivatives into retail friendly instruments.  The derivatives that have caused a great deal of our current pain, however, have been OTC or Over the Counter contracts.  The difference between the two is that exchange traded options are just that, they are traded on open exchanges with full price transparency.  In an exchange traded sale the last sale price, a bid and an ask are printed to the tape for all to see.  OTC contracts however are traded much more like stocks were in the days of street corner trading at  Broad and Wall Street, with individual buyers striking deals with individual sellers, generally without much knowledge of recent pricing to any non-market making participants. The problem with that type of market is that the pricing mechanism is terribly inefficient because information asymmetries are rampant.

New regulations are threatening to change the OTC market, and make it resemble the exchange traded market with the implementation of a central clearing agency.  While this change will certainly be bad for the profit margins of market makers in the near term, it may ultimately become a boon creating a larger market appetite and ultimately driving  up volumes for market makers as the market grows.  It also would more than certainly help create the marketplace that mssrs. Greenspan, Cox and other great de-regulators were hoping for, one in which systemic market risks are muted because risk has been sold to those with the appetite.

I postulate that one of the real tragedies of 1990-2008 was not that the counter party system was too large or unregulated, and not that derivatives were “weapons of mass destruction”, but rather that the OTC marketplace was fundamentally flawed by its own opacity.  We may learn, and I hope sooner than later, that a ubiquitous counter party system might in fact be a good thing, as long as buyers and sellers are charging the right price for risk.

There were a good number of intelligent investors who were massively short the markets, and not shy about their views on the financial sector from 2006-2008.  For some reason though their fervor never caught on.  I suppose a great scandal may arise when someone starts looking into the possibility that collusion in the OTC market may have misstated and mispriced many of the risks in the housing market by keeping the price of credit insurance artificially low until it was too late.

In the meantime, for the rest of us, yesterday’s Nasa technology becomes tomorrows household appliance.  As such I imagine that derivatives may play an even larger role in our futures than most people have considered recently, particularly with volatility at sustained high levels. Equally, something new, sexy and profoundly dangerous is bound to incubate in the minds of  bankers aspiring to return to the bonus checks of yesteryear.

U.S. Draft Law Would Ban Most Trading in Credit-Default Swaps
Matthew Leising, Bloomberg, January 28, 2009


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