A Secretive Banking Elite Rules Trading in Derivatives

http://www.nytimes.com/2010/12/12/business/12advantage.html

by wallflower • 16 years ago

53 34 16 years ago

I don't care what the market players do, as long as the taxpayer is not on the hook when things blow up in their faces. The fact that we are lets them take dumber risks.

joe_the_user4• 16 years ago

You've got to understand that when you create a massively interlocked system whose collapse would seem likely to bring the entire economy down with it, you've institutionalized that system's bailout without any laws being passed.

And yes, that lets the risks pile up too.

And no, I don't think the bailout left us better off but the fix was in long before October 2008.

stretchwithme4• 16 years ago

The key phrase is "would seem likely". And it seems even more likely with people like Hank Paulson claiming that if he doesn't get a slush fund, the world will end. Even though its really just profits at Goldman Sachs that would end.

That doesn't mean we can start unwinding things by rolling back the individual policies that are causing the risky behaviors.

The government could, for example, ensuring only 80% of their bank deposits. We could start phasing out subsidies for housing by 2% per year. We could let the market set interest rates.

Of course, the people in charge (regardless of which party) seem to think only more government interference in the economy could possibly help. They seem incapable of examining anything they've done or admitting any errors.

igravious4• 16 years ago

How are things coupled? And how to we decouple them? Serious questions.

jbjohns• 16 years ago

Even worse, those who picked well missed out. There were banks who realized this was going to blow up and stayed out of it with the idea of buying the banks that failed. What did they learn from this crisis? They missed out on millions by avoiding the subprime frenzy.

fooandbarify2• 16 years ago

The world of high finance has intrigued me as of late. I recently watched the documentary "Inside Job" and it made me feel incredibly stupid, so I've set out to learn what I can about the industry. What an odd little world of its own.

I can't even say any more than that about the article - it would be like when my Mom tries to talk about programming. I just thought I'd drop a little plug for the film here (no affiliation) in case anyone else wanted an interesting and easy starting point for this stuff :)

Nrsolis2• 16 years ago

Inside job is a bit sensationalistic.

That said, you can probably learn a decent amount by reading a book called "Hedgehogging.". It goes into some of the cultural aspects of finance.

Just keep in mind that "trading" is all about having a better eye for value than the other guy. In every respect. If you're bad, you'll get fleeced. And by you, I mean everyone who has placed money with you.

fooandbarify2• 16 years ago

I thought it might be. I'd be curious to hear a more balanced perspective on the crisis, and I suspect part of that will come as I just inform myself about the industry as a whole.

Thanks for the recommendation - I will be buying Hedgehogging this week if I can't find it at the library.

mynameishere• 16 years ago

Their lock on the market is less than 100 percent.

http://tinyurl.com/22pu34p

murcielago• 16 years ago

I am writing from my "other" account and I make a living in financial modeling.

While in general the article is true, as always, journalists fudge truth just a bit to sound more sensationalistic.

> But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

Sure there are fees, but most of the premium is the price of risk, the price of the insurance if you will. While banks sometimes do some proprietary pricing enhancements, the foundation methods are usually the same and can be picked from books (like the bible of derivative pricing by John C. Hull) and papers. I know for a fact that big commodity companies (e.g. oil companies) have their own financial analysts on staff to double check derivative pricing. And it is not just that this allows you to haggle with the banks - you do no want to get derivatives that are too cheap either. That may be a result of incompetence or a sign of trouble - should the derivative seller pay to you they will not have enough capital to cover their obligations. That is exactly what happened with AIG and Lehman Brothers.

Now, Robison Oil may not be that big to have financial analysts on staff, but they could use third-party pricing consultants, at least.

pmorici2• 16 years ago

"proprietary pricing enhancements", that sounds like a scam if I've ever heard one.

mkramlich• 16 years ago

step 1 in their evil scheme: hide all their plans behind a NYT login wall

known• 16 years ago

Govt will not take any action because Wall Street is the highest tax payer and job creator.

parallax7d• 16 years ago

Govt will not take any action because Wall Street floods politician's election campaigns with dollars so they play ball. If they don't play ball, Wall Street funds a challenger to the seat.

igravious4• 16 years ago

How does Wall St, collectively and en masse decide and go about doing this? I'm not saying that they don't - I think that it has been fairly well reported that the sums of money coming from Wall St. as campaign contributions are large - I would just like to know if there is any coordinated mechanism or is it a kind of wisdom of the financial crowds ...

tmsh2• 16 years ago

It's a pretty amazing thing to see a NYT reporter write a five page story about 'derivatives' and not realize that the people she's talking to are referring very specifically to CDS derivatives and heating oil derivatives only.

This was my favorite quote:

To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton.

Right.... First of all, get the name right. It's significantly been called the CME Group for years now -- and refers to the fact that this is a collection of all sorts of markets, the vast majority of which are financial derivatives. Ken Griffin proposed a very specific trading platform for CDS derivatives a couple of years back. The CBOT and CME (merged as the CME Group) meanwhile have been trading other financial derivatives, as the majority of their business, for three decades now.

The key point that is missed in all this imprecision -- is that CDS derivatives markets are not like other derivatives markets -- which are regulated. They are contracts that occur between large financial institutions only. That is the 'secret'. The rest is just the equivalent of a high school tourist at the visitor's desk.

That said, she's in the general right direction (I won't say ballpark). But yeah, it's almost like complex businesses require three levels of understanding that people go through:

  (1) it's a conspiracy
  (2) it's actually not so bad
  (3) there are targeted ways to improve it

Fields shrouded in first-semester textbooks, though mired in specific cases of catastrophic misuse (financial crisis), I suppose take a little more effort to get to step 3....

igravious4• 16 years ago

I think that most "lay" people would know about the exchange in Chicago by its old name. It's not like the name change of 2007 is decades ago. And I'm guessing that CME Group stands for Chicago Mercantile Exchange Group so referring to the institution as the Chicago Mercantile Exchange is hardly a howling mistake. And presumably derivatives are a type of contract, and the derivatives are based on commodities, and oil is a commodity, thus the reporter seems to be largely right.

Instead of being pedantic and snarky why don't you enlighten us all instead of using acronyms for everything? CBOT appears to be the Chicago Board of Trade. But CDS? Is this the famous credit default swaps that helped bring about the current mess that we are in? And the banks are unwilling to have a light shone on these dealings. ? What a surprise. She doesn't imply it is a conspiracy - she actually shows that there appears to be collusion and monopolistic practices. There is no, "we think they are up to something but don't know what", it's "they are up to something and aren't playing ball".

tmsh2• 16 years ago

Instead of being pedantic and snarky why don't you enlighten us all instead of using acronyms for everything?

Okay, I'll try for a little bit. I should be programming. But a little bit of history. I apologize for sounding pedantic or snarky.

In the 1900s up until the 1970s, the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) traded mostly agricultural products. A similar market existed in New York (NYMEX). These exchanges were created so that (as alluded to in the beginning of the NYT piece) wholesalers, farmers, people with a heating oil business, etc., could hedge the risk associated with the price of their commodities (due to weather, circumstance, etc.). Eventually these contracts became standardized -- they referred to the same # of bushels, and they were backed by clearing firms and central clearing houses at the exchange that served as buffer between these hedgers (who would 'hedge their bet', if they were more interested in selling at a locked in price and not worrying about the changing prices of the market), and speculators (usually local traders, or 'locals'), who would assume this risk.

These standardized future contracts fall under the category of 'derivatives', because they 'derive' from the current price of the commodities (often called 'cash' or 'cash instruments'). It turns out that there is overlap in how you create other more complex derivatives related to these futures contracts. So you can create options on these contracts. The options 'derive' from the price of the futures, etc. Sort of similar to higher order derivatives in math (so blaming 'derivatives' in general usually irks people in the industry because that's like blaming 'acceleration').

But there are different cash instruments you can use, and different ways you can form these instruments. So in the early 1980s, due to tax incentives in Illinois, and a couple of other reasons, the CME introduces the Eurodollar future. This is the first major financial future. The cash product here is interest rates (usually the LIBOR rate -- hence, the 'Euro' -- a standard short-term interest rate used by banks). So now financial institutions are starting to see that they can do this same type of hedging of their bets (they're the 'farmer' or 'heating oil producer' in this equation). If they want, they can now hedge their exposure to interest rates.

But why stop there? Futures contracts have the benefit of different taxation (capital gains taxes in Illinois are lower than elsewhere -- I don't know how much this has changed, but, e.g., this is one of key things a good reporting piece could focus on -- the justification is that speculation and capital gains from trading is risky and deserves to be taxed less -- because of the good to the economy that it provides, etc. -- but I mean, that's worth debating). And futures contracts also have the benefit that they're standardized and accessible to anyone with a terminal. So before you know it futures on stock indicies are introduced (the largest volume contract in the U.S. -- is the S&P 500 family of futures contracts). And around this time -- in the early 90s, things start to go electronic for the first time.

Bond futures are also introduced (at the CBOT). And this allows large financial institutions to offset risk more easily with their treasury bond portfolios, etc.

The key thing here though is that all these instruments, all this financial futures -- and all the options on financial futures that created -- they're all regulated. They're all closely watched by the CFTC and other regulatory bodies.

Enter the problem. Credit Default Swaps. These are non-standardized contracts drawn up between bulge-bracket firms in New York and insurance agencies to deal with the risks associated with mortgage securities. This is a huge, multi-multi-billion dollar industry that isn't regulated because it's still in its infancy and the participants have never been truly brought into the light.

Financial engineers, having seen how derivative contracts can be used to offset or control risk -- decide to draft these contracts to deal with mortgage-backed securities. The problem with mortgage-backed securities -- I don't know for sure. But I know they've been problematic from the 80s onwards. The bundling of home loans by New York has just never worked out for everyone (and Warren Buffett bailing out Salomon didn't fix the core of the problem -- in fact, arguably it glossed it over and left it as a potentially hazardous situation for two decades later -- though that's highly controversial, and just my sense -- the rest of what I said is hopefully pretty well accepted).

So creating financial derivatives for CDSes doesn't work in an unregulated manner. So seeing things collapsing, and seeing an opportunity to be involved in a huge new market, Ken Griffin proposes that CDSes should be traded in a more open manner (in 2008). CME Group (which is a merger of all three major futures exchanges in the US -- CBOT/CME/NYMEX -- another thing a more targeted reporting piece could focus on -- there's a potential monopoly -- see their relationship with ELX, etc.), I'm guessing, correctly foresaw that they didn't want to be anywhere near CDSes with the political backlash coming. So they wisely turned down his idea. But I could be wrong there -- have no close familiarity with what really went on.

So that's a little history. I don't know the specifics of the ICE clearing house conspiracy meeting whatever. But there are hundreds of these 'working groups' for new types of derivative products. They're traditionally just large market participants voicing their concerns about how things are going to be traded (the software involved, the types of contracts, etc.). But...it's not a conspiracy.... Not any more than ISO / HTML5 working groups are conspiracies between tech companies to push their interests (I mean there's always going to be a little bit of that). But these are traditionally actually very good things -- people coming together to determine how to trade things in the open.

The problem is Goldman Sachs picking up the phone and creating a custom contract with AIG to insure themselves against a mess of mortgage-backed securities that they got themselves into. The problem is that (a) they could trade these to begin (see THE INSIDE JOB, etc. -- for the rationale behind Glass-Steagall, and the problems with its repeal) and (b) that this didn't happen in a free, open, accountable market and of course (c) that they got bailed out because they were so integral to the financial markets to begin with (which wouldn't happen if part (a) were addressed).

But I mean obviously if you're going to start regulating things more closely, it's good to figure out exactly what to regulate. But I suppose I really should get back to programming...

DanielBMarkham• 16 years ago

I would add a fourth step

  4) This just represents a simple architectural 
    programming pattern and should be completely 
    open and commoditized

Of course, like the good programmers we are, most times we jump from step 1 to step 4 without thinking about the important details in steps 2 and 3 ...

cynicalkane• 16 years ago

Many people still call it the Chicago Mercantile Exchange, or just the 'Merc'. I know this because I work there. You're right about the rest, though.

pmorici2• 16 years ago

I saw a good Frontline documentary on this the other day, http://www.pbs.org/wgbh/pages/frontline/warning/view/ apparently this whole mess started back in the 90's and the head of the CFTC then, Brooksley Born, wanted to put rules in place then to make the derivatives more transparent but was vehemently opposed by Greenspan, Rubin, and Summers. Turns out that the current head of the CFTC, Gary Gensler was one of the deputies of the three guys opposing any regulation of derivatives in the 90's. The three actually went so far as to get a law passed saying that the CFTC couldn't regulate derivatives.

Bottom line is anyone that acts surprised by the lack of regulation shouldn't be because Congress voted on and passed a law specifically prohibiting regulation of derivatives in the 90's. A law that was promoted by the same people who now run all the US government agencies like CFTC, Treasury etc...

patrickk• 16 years ago

Single page: http://www.nytimes.com/2010/12/12/business/12advantage.html?...

A Secretive Banking Elite Rules Trading in Derivatives

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