Paul Volcker, legendary former chairman of the Fed argued recently that financial innovation has not brought any great benefits to society. Derivatives are, as you write in your book, complex instruments. But complexity destroys transparency. Simplicity would generate confidence. What can be done to break this kind of abuse and cheating due the complexity?
Industry lobbyists focus on the use of derivatives to hedge and manage risk promoting investment and capital formation. While derivatives can play this role, derivatives are now used extensively for speculation – “manufacturing” risk and “creating” leverage.
Derivative volumes are inconsistent with “pure” risk transfer. In the credit default swap market (CDS) market, volumes were in excess of four times outstanding underlying bonds and loans. Speculators may facilitate markets but recent experience suggests that in stressful conditions they are users rather than providers of scarce liquidity and amplify systemic risks.
Relatively simple derivative products provide ample scope for risk transfer. Increasingly complex and opaque products are used to increase risk and leverage as well as circumvent investment restrictions, bank capital rules, securities and tax legislation.
Few, self interested industry participants are prepared to admit the unpalatable reality that much of what passes for financial innovation is specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.
To control this would require banning certain types of derivative and preventing them form being used other than for hedging, exactly the same as insurance.
Until regulators and legislators understand and are prepared to address these central issues, no meaningful reform in the control of derivative trading will be possible.
The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.
Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles?
Derivatives and debt are the needles of finance and bankers will continue to supply them to for the foreseeable future as long as there is money to be made in the trade.
What role did financial innovations like CDS play in the crisis? What has to be done to reduce a systemic risk of a major dealer failing with derivatives for the entire economy?
CDS contracts and other innovations allowed inceased leverage and speculative positions to be created. For example, the simplest analogy is that CDS contracts are like insuring your house except that you don’t have to have a house and anybody can buy the insurance contracts. This has the effect of amplifying the given losses for a specific event. For example, CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%. It increases the embedded leverage in the financial system to a specific event namely the default of the reference entity. It also may absorb available liquidity and capital creating systemic issues.
The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of the Lloyds market. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified.
The transfer of risk assumes that all parties along the potential chain perform their contracts. Any failure in the chain of risk transfer exposes other parties to the risk of insolvency and default. Defaults and failures in CDS contracts may quickly cause the financial system to become “gridlocked” as uncertainty about counterparty risks restricts normal trading. The bankruptcy of Lehmans set off a chain of just these events causing financial markets to become “frozen” in September and October 2008.
As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Derivatives markets generally may have higher concentration risk than considered desirable or acceptable. The CDS market is similar in structure to the overall derivative market with less than 10 dealers having the major share of the market. The potential impact of a bankruptcy filing by Bear Stearns and AIG on the OTC Derivatives market, including CDS contracts, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the two firms.
If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between $33 billion and $158 billion *. Barclays Capital estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.
CDS contracts may under certain circumstances create volatility and uncertainty instead of reducing risk. For example, the coupling of participants and long chains of risk transfer may mean that uncertainty about the financial position or solvency of any firm is quickly transmitted throughout the financial system rather than being confined to firms directly exposed to the distressed entity. Attempts to hedge this risk or close out positions may increase volatility. There are also negative feedback loops. If reference entities start to default then insurers, hedge funds and banks are affected. If the economic climate worsens and defaults rise then the overall ability to rely on these hedges may decline. The extent of the diversification of risk may diminish exactly when it is most needed.
* See Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy – BNP Paribas Corporate & Investment Banking.
What is the most important cause of the current crisis?
The Global Financial Crisis is the result of too much debt in the financial system. The early 2000s were a period of “too much” and “too little” – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the pages of the Wall Street Journal: “No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.”
It is also the result of the increase in the role of finance in modern economies. New paper economies emerged directly from the demise of the gold standard that removed restrictions on the ability to create money, especially debt. Advances in computing, developments in economic thought, shifts in regulation and changes in social attitudes transformed the world. Finance inexorably displaced industry with trading and speculation becoming major activities. People increased consumption, often fuelled by ever increasing levels of borrowing. In industry, financial engineering replaced real engineering.
In the U.S.A., financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The combined stockmarket value of these firms grew from 6% to 23% over the same period. Similar trends were evident in many other countries. Financial services moved from being a traditional support function to a major driver of economies.
Much of this new activity was not productive. It did not generate true value and did not represent direct additions to the good and services produced in the economy. Much of it was directed at increasing the level of debt, the circulation of money as well as trading and speculation. New financial techniques became ways to move money back and forth with bankers getting a cut at every turn. New products allowed everything to be traded facilitating speculation and enabling the manufacture of new risks for investors seeking to make money. Banks, investment managers and hedge funds gloried in using capital supplied by investors to trade. The process may have created little value but provided extraordinary rewards for the immediate practitioners.
Originally published at Acemaxx-Analytics and reproduced here with the author’s permission.