Derivatives, Clearing-Houses & Exchanges: Transparency Solves All Problems ???

You don’t need to understand the different types of derivatives, says Ezra Klein of the Washington Post,

You don’t need to understand the different types of derivatives, says Ezra Klein of the Washington Post,

You don’t need to understand the different types of derivatives, says Ezra Klein of the Washington Post,

who is supposed to be on the cutting edge on mainstream financial and economic “journalism,”

but who, at least from this piece, gave us the feeling he leaves a lot to be desired.

But check it out for yourselves, and tell us what you think 😉 . [br]

All you really need to know, Klein continues, is that financial firms trade derivatives, they’re worth an extraordinary amount and there’s a category of them that’s almost totally unregulated.

That’s a big part of the reason why the financial crisis was as severe as it was:

We had no idea how many derivative contracts these major firms had with each other — and with everyone else.

So when Lehman fell and other banks threatened to follow, no one could predict the consequences.

“What we mean when we say a company is ‘too big to fail,'” says the Roosevelt Institute’s Mike Konczal, “is that they have too much derivative exposure too fail.”

So, derivatives: bets that other firms have with one another and that are big enough to crash the financial system if a firm defaults, but not bets that we know about or regulate. That’s not so hard, right?

And that’s the end of the derivatives lesson for the day.

The concept you really have to know about isn’t derivatives, but the answer to the derivatives problem: The clearinghouse …

Right now, derivatives trades are made bilaterally.

That is to say, I make a deal with you for a price that we both agree on.

AIG demonstrates the problem with that strategy: One of us might sign more of these deals than we can actually afford if the bets don’t go our way.

The clearinghouse solves that problem.

It stands between me and you and manages our bet.

So when we make a deal, we’d both have to post up some initial money to the clearinghouse.

 

[EW: Now here’s where you have to pay close attention:

Note Klein does NOT say ALL the money to cover the bet – just “some initial” money”.

This is a MAJOR flaw in his assumption that the clearinghouse “solves” the problems of derivatives:

While certainly USEFUL, in the end it boils down to yet another way to “bet on margins” …

Now, the margins MAY be a bit higher than usual – but by allowing firms to put up only PART of the money,

the way is once AGAIN opened for there to be more money at play than there are adequate funds to back them up.

Nice try, Ezra, but it doesn’t quite work as “smoothly” as you imply 😉 ]

 

And we have to update that money every day. [br]

The trade is “marked to market,” which is to say, it’s evaluated based on what would happen if it had to be settled today.

Whoever lost ground that day has to post more money to the clearinghouse.

And all participants have to give the clearinghouse a bit more money beyond that in order to make doubly sure the clearinghouse can pay the bets back.

This does a couple of things.

First, it means we know who has bets with whom. Rather than a web of derivatives, it’s a map.

Second, it means we know everyone can pay off their bets, and we can see if one firm or another is suddenly taking massive hits every day.

 

[EW: Unfortunately, though, it DOESN’T mean we know everyone can pay off their bets –

it simply means that we have an idea of who is most LIKELY to get hurt if their bets don’t pay off …

Again, sorry, Ezra … the “solution” isn’t so simple 😉 ]

 

There would be no AIG-like situation, where they seemed to be doing fine and then, all of a sudden, seemed about to blow up the financial system.

 

[EW: Don’t be so sure 😉 ]

 

We would’ve watched the wave build rather than only noticing when it was breaking atop us.

So that’s the first, and most important, step.

The second piece of the puzzle is exchanges.

Stocks are traded on exchanges. So are some derivatives.

The upside of an exchange is that it creates pricing transparency.

If you and me make a deal and don’t tell anyone about it, no one knows the price.

That’s fine for you and me, of course, but what we saw in the financial sector was that we had trillions in derivatives that we couldn’t price …

Wall Street doesn’t want exchange-trading because, well, it will reduce their profits.

They can skim much more off the top if they’re negotiating one-on-one than if they’re in a competitive market where everyone can see prices.

The other major policy proposal is Blanche Lincoln’s effort to spin the parts of banks that trade these derivatives off from the rest of the bank (at least if the bank wants access to the Federal Reserve’s low rates).

So rather than there being a Bank of America that trades credit default swaps and holds your deposits, there would be a Bank of America that held your deposits and a BofA spin-off that traded derivatives.

The hiccup in all this is what’s called “the end-user exemption.”

There are two types of folks who use derivatives:

Companies who are legitimately hedging future risks — say, an airline that’s worried about the price of fuel in 2015 —

and firms — and sometimes companies — that are just trying to speculate.

The legitimate hedgers don’t necessarily need to be regulated in the same way the speculators do.

The trick is writing that exemption narrowly enough that speculators can’t slip through the door as well.

An important note to all this: Unlike most of financial reform, which is really about changing the powers of regulators, this is really a reform of how Wall Street conducts its business.

It is, in other words, “Wall Street reform,” which is the term Democrats prefer to use.

And if the end-user exemption remains limited, and clearinghouse and exchanges become the norm, we’re in pretty good shape:

Clearinghouses will take care of the main risks derivatives pose to the system.

Exchanges will allow us to price the products and detect movements in the market.

Get this right, and financial reform might just work. Get it wrong, and it definitely won’t.

 

[EW: Unfortunately, we have no idea by what HE means when says “get it wrong”,

and, given that the situation is a lot more complicated than he makes it seem,

there is NO reason to think this is going to bring “financial reform {that} might just work” …

not that there’s anything wrong with his suggestions – they may certainly be NECESSARY …

but they are absolutely NOT SUFFICIENT …

And so, at least as far as we’re concerned, the problem of derivatives remains FAR from solved … 😉 ]