Friday, May 15, 2009

The Flight to Simplicity in Derivatives

Complexity is one of the demons that makes our financial markets crisis prone. Much of the complexity arises in the specter of derivatives and other “innovative” products. To reduce the risk of crisis we must exorcise this demon. We need a flight to simplicity.

Geithner’s proposal for new derivatives regulations, which includes centralized clearing and exchange trading for standardized derivative products, moves us toward this goal. A stated objection to this proposal is that the door remains open for complex OTC versions of swaps and derivatives. Or worse, that having the standardized products out in the light of day will only accentuate the demand for the more shadowy and opaque versions of the products.

I don’t think that is the way things will play out. More likely is that this proposal, properly executed, will be a major step forward in improving the transparency and efficiency of the market place, and will shore up the market against the structural flaws that derivative-induced complexity have created.

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

Furthermore, the thought-leaders on the buy side will add their own hurdles to the more complex OTC products. I would not be surprised if many investors require derivatives taken on their behalf be of the standardized, exchange traded form, or that if an alternative is presented, it has to be approved by their firm’s CIO or risk manager. If this comes about, there won’t be too many instances where a complex OTC is pushed forward, because for most legitimate purposes the standardized products, on their own or in combination, will be found to do the trick.

Which gets us to the illegitimate purposes. Many of the complex innovative products are used for what might charitably be called non-economic purposes. Like allowing firms to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, or avoid taxes that they are supposed to pay. I have discussed this more in an earlier post, My “Non-testimony” on the Regulation of Swaps and Derivatives.

If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line, an investor came to an investment bank and said, “Hey, I got a problem. You think you can help me out here.” His problem was something along the lines of, “My boss, he won’t let me trade mortgages, but I want to get my portfolio into these mortgages.” The ever-accommodating investment bank came back with an index amortizing swap.

Then – or maybe at the same time – the innovations went from "problem" solving to problem creating. Investment banks found clever ways to give their clients an extra twenty-five or fifty basis points by having them take on tail risks. These risks were subtle and infrequently occurring; most of the time things worked out. But every now and then, there were the blow ups; the likes of Orange County and P&G.