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A question about derivatives

I'm going to do a series next week explaining the various elements of financial reform, as I think this debate has moved a whole lot faster than public understanding. But for the purposes of this post, it's worth very quickly sketching out how derivatives work.

Derivatives are named derivatives because their value is, well, derived. So imagine some very real mortgages. Now imagine I place a bet with Goldman Sachs that the mortgages will default. That bet is a derivative. It's a financial product that only exists atop another financial product.

Right now, most derivative contracts are written by financial companies at the behest of clients ("end-users," in industry lingo). Then the financial company either keeps the other side of the trade or sells it to someone else. Either way, it's good work for the financial companies which make a ton of money from writing these built-to-order contracts and making these markets (Paulson, for instance, paid Goldman Sachs $15 million to help him create the Abacus trade that caught the SEC's eye).

The expectation is that if derivatives move onto a more transparent, competitive market, fees for financial firms will go down, which should be good for end users. But the end users have been very worried about derivatives reform. In an interview with the Washington Independent today, Brookings' Bob Litan hypothesized about why:

One theory is that they just don’t trust or don’t believe the regulatory process will bring us to that brand new world of exchange trading. They do not trust it will happen, and therefore are more comfortable with the world as it is. Then, if exchange trading does happen, they do not believe there will be a compression in the spreads, contrary to all of financial history. The stock market shows us that spreads massively narrow when exchange-trading is put in place. So, they just don’t trust or believe this is going to happen, for some reason.

Another theory is that in effect they’re doing the dealers’ bidding, and the dealers have enormous incentives to keep the current system under place as well as leverage over their clients. My understanding if that you’re a big buy-side user, you don’t spend time a lot of time shopping between Goldman Sachs, J.P. Morgan, Morgan Stanley. You just have your favorite dealer.[...]

Then, there’s a third reason which makes the most sense. And that is — well, it makes sense in the short run. There is a classic collective action problem here. Nobody wants to pay to make the system safer for everybody. It’s like taxes. I don’t want to pay for defense, I want you to pay for defense. If I can get you to pay, then, I get a free ride.

So, as it is, since these companies might be getting good deals now. Their costs will go up at the beginning when they have to start posting collateral. If the system evolves over time, we’ll get to that nirvana with clearinghouses and lower spreads. But if these companies are just thinking about the short term, they might oppose the change. That’s a short sighted but semi-rational thought process. And it’s just people acting in their own interests.

The other reasons I've heard are the end users they don't want to commit to posting collateral or making big changes before they see what the new world will look like. In this telling, they want an exemption not because they're sure they'll use it, but because they want the option to use it if they don't like whatever the result of reform is.

Those theories make some sense. I'd also like to hear what Economics of Contempt thinks of this issue.

By Ezra Klein  |  April 16, 2010; 5:03 PM ET
Categories:  Financial Regulation  
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You use "end user" like it refers to transactions between Lehman Brothers and your grandmother, instead of Deutsche Bank and Goldman Sachs.

Also, I think most sane people agree that /some/ derivatives are sufficiently liquid to trade on exchanges such that outcomes would improve, but this doesn't acknowledge that bilateral contracts can improve outcomes with illiquid CDS contracts.

Lastly, collateral reqs are just another name/form for capital requirements. Is it that surprising that the reaction is any different?

Posted by: dgs290 | April 16, 2010 6:32 PM | Report abuse

Ezra, here's an alternative explanation:

There are (broadly) two kinds of "end users" for derivatives: hedgers and speculators.

Derivatives were first utilized and created for the benefit of the hedgers (which is not the same as a hedge fund), who would use them to reduce their uncertainty (e.g. a farmer locking in a price for corn six months from now). For hedgers, derivatives are a tool that helps them run their business.

Speculators, on the other hand, are not interested in the underlying security (e.g. oil or mortgages), except insofar as it affects the price of the derivative. They make their money by exploiting mispricings in the derivatives market. The greater the mispricing, the greater the arbitrage opportunity.

In recent years, the market for derivatives has been driven by the demand for speculative opportunities, not the ability to reduce uncertainty for one's business. With this in mind, it seems fairly obvious why the exchanges are so unpopular in the derivatives market. It is mostly made up of people who *benefit* from the inefficiency in the market.

To put it another way, the exchanges will lower the barriers to entry in the derivatives market, making the market more efficient. While this is good for the economy and potential entrants to the business, it's clearly bad for those who are already established, as they are the beneficiaries of the market's inefficiency.

One other thing: While the banks make a great deal of money underwriting derivatives, they also make a lot (more?) from trading derivatives. It seems unlikely that they'll care much if the exchanges reduce the fees they pay themselves.

Posted by: sterlinm | April 16, 2010 8:08 PM | Report abuse

"Any change will be for the worse; therefore it is in our interest that there be as little change as possible."

Prime Minister Lord Salisbury

Posted by: dwbarker1 | April 16, 2010 8:20 PM | Report abuse

"Derivatives are named derivatives because their value is, well, derived."

This sentence made complete sense to me.

As for the made incomplete sense.

Analogies, Ezra. Think analogies.

Posted by: slag | April 16, 2010 9:35 PM | Report abuse

Why does this stuff always sound to me like going to the local bookie to bet on point spreads?

Posted by: ChicagoMolly | April 17, 2010 10:42 PM | Report abuse

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