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.
April 16, 2010; 5:03 PM ET
Categories: Financial Regulation
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