Felix Salmon

Steve Waldman has a really

great post on derivatives, which clearly and compellingly sets out the Case

for Worry.

The gist is that in a $300 trillion derivatives market, there’s bound to be

a lot of counterparty risk somewhere. And given how the market is set up, one

major counterparty failure could set off a nasty global chain reaction, with

serious systemic consequences.

Another way of looking at it: what is that $300 trillion made up of? Let’s

say that everything is double-counted, and that you can somehow carve it up

ito +$150 trillion of positions on one side and -$150 trillion of positions

on the other. Then in theory the two add up to zero, and there’s no risk. But

in the real world, when you take sums as mind-bogglingly enormous as $150 trillion

and try to add them up, you’ll never be perfectly accurate, and there’s likely

to be a tiny error in there somewhere. Let’s say that tiny error nets out at

one tenth of one percent of the total. Well, that tiny error is now a whopping

great $300 billion risk.

As promised, here’s Jesse Eisinger’s response to my earlier blog

entry on derivatives. It’s a good one, too, so I’ll let him have the last

word.

My first blog entry on Portfolio! So exciting.

First of all, I think we agree on much here. Derivatives are mostly used as

a form of insurance. (As an aside, the derivatives industry doesn’t like

the comparison to insurance, because insurers typically are heavily regulated

and required to hold minimum amounts of capital against their policies. Derivatives

traders are not. Hmm.) The industry types prefer the words “hedging”

or “protection.”

These instruments are, I agree, used mainly to smooth cash flows, make markets

more predictable and spread risk from those who are vulnerable (say, farmers)

to those who want it or can handle it better (commodity speculators).

And I will concede a bit of First-Issue-of-Big-Glossy-Magazine fear-mongering

in referring to nominal figures when talking about the size of the markets.

The headline of my column uses the $300 trillion amount for the whole derivatives

market. In the column, I refer to the $26 trillion amount for the notional amount

outstanding in the credit default swaps market. They are the real nominal figures

but they are a bit hyperbolic. I disagree they are meaningless. They show how

much the derivatives markets have grown, for one. Answer: a lot. These are the

fastest growing markets in the world.

But there are some inherent concerns about derivatives. One is that they are

a form of leverage. Anyone can write a credit default swap on Felix Salmon Fisheries

Corp., take a fee, and be on the hook for some big sum in the event that Felix

goes belly up. (Groan.)

Maybe the writer can handle the risk and maybe not. You think that “most

derivatives” are not “speculative” investments. Oh really?

How do you know? What’s the breakdown of prudent hedging compared with

speculative? You don’t know. I don’t. No one knows how much leverage

there is and how much speculation there is.

What we do know is that the derivatives markets are large, liquid, for sophisticated

investors, and are largely off the radar screen. That is pretty much the platonic

ideal of a natural environment for speculation. Now speculation has a bad connotation,

but it’s not inherently bad. Some of the speculation transfers risk properly.

If the speculators are taking risks that they can handle, that is. Amaranth

couldn’t handle the risks, but the fallout was minimal. Long-Term Capital

Management couldn’t either – but the

fallout was hardly minimal and the fund needed a massive bailout.

The question becomes whether the users are accounting properly for how much

exposure they have and whether they are doing proper due diligence on their

counterparties. Warren Buffett writes that the accounting can be screwy and

that both sides of derivatives trades can immediately book paper profits.

I’ll trust him on that.

Are derivatives being valued properly? Gen Re wasn’t the most cutting

edge derivatives player but they were a financially savvy group of guys. They

didn’t value some of their instruments correctly. Maybe they are the exception,

but I doubt it.

The sophisticated institutions supposedly have good risk controls that should

prevent similar problems, but do they? Amaranth and LTCM were widely viewed

as having top-class risk controls. That doesn’t give me much faith in

risk controls, especially in a crisis.

Does that mean we are going to have a crash? I don’t know. I agree that

it’s a zero sum game in theory and that they cannot wipe out wealth of

non-participants per se. But their prices are derived from securities. If the

securities markets sneeze, you say the derivatives markets are the tissues;

I say they might be the virus. That’s where the worry about systemic risk comes

in; if the gains are concentrated in a very small number of players but the

losses hit a big bank, look out.

And the concept of a crash doesn’t simply mean wealth-destruction. These

markets can crash in a very real way: They can go away. There are relatively

few major derivatives dealers; in a panic, they won’t pick up their phones.

It’s conceivable that one day investors will wake up and the CDS market

or some part of the collateralized debt obligation market or something else

won’t be open for business – as the subprime mortgage originators

essentially found a few weeks ago. (Obviously, this is a matter of price. Things

settled down in subprime and now the subprime window is open. But mortgages

are being packaged and sold at a discount, rather than a premium.)

So what do we have? We have relatively new markets that are wildly popular

with risk-hungry investors, growing like weeds, haven’t been tested in

a crisis, and have the potential to increase leverage dramatically. Furthermore,

mostly derivative transactions aren’t transparent to other market participants

or the regulators.

And Felix says, What, Me Worry?

Are you scared by the $300 trillion derivatives market? Jesse

Eisinger is. Since his piece in Portfolio came out, Jesse and I have talked

about it at some length; he ended up telling me to write a blog entry which

he can respond to. Watch this space for Jesse’s reply!

So. Is the derivatives market scary? In a word, no. That $300 trillion number

– a good five or six times gross world product – is meaningless.

It includes untold numbers of contracts which cancelled each other out years

ago, and it’s based on something called "notional amount" which is

vastly larger than the actual sums of money changing hands. An interest-rate

swap, for example, might pay out the difference between a fixed rate of 6% and

a floating rate of 5%. On a notional $1 million swap, the total payment is just

$10,000 per year.

What’s more, that payment is probably being used to hedge some other kind of

interest-rate risk elsewhere. Most derivatives are not a speculative investment,

but are in fact part of an attempt to smooth cashflows and make unpredictable

markets more predictable. If you’re an airline, for instance, you’d much rather

lock in your fuel prices than be subject to the kind of price volaitility that

jet fuel has undergone in recent years. And if you’re an equities investor,

you can use derivatives to protect you from any stock-market crash.

The fact that derivatives are global is a good thing. Jesse quotes the CEO

of General Re as saying that "a financial crisis is likely to be a global

event, not a local event, and derivatives will probably help make that happen.”

To which I say: great! A problem shared is a problem halved.

It’s worth remembering, here, that the derivatives market can’t crash, in the

way that the stock market or bond market can. It’s a zero-sum game where for

every loser there’s a winner. Theoretically, the net amount of wealth tied up

in derivatives is zero, which means that no wealth can be destroyed by a market

event. In practice, says Jesse, there are some derivatives trades in which both

counterparties mark a profit to market. That seems weird to me, but in any case

the total amount of wealth at risk is confined to such aberrant valuation procedures

within sophisticated financial institutions. If you have money in a pension

fund, you’re worried about securities markets crashing. You really don’t have

any worries at all about valuation risk in the derivatives market.

The great thing about derivatives is that short of a major investment bank

failing, there’s very little systemic risk involved with them. Investors such

as Robert Citron or Brian Hunter can and do

blow up now and then. But all those concentrated losses simply reflect gains

elsewhere in the system. And as for the investment banks, they’re subject to

exactly the kind of regulations which Jesse claims are needed.

Yes, derivatives are difficult to value, and can end up giving an unwary investor

nasty losses. But they perform much more good than harm, in areas from agriculture

to catasrophe insurance. The risks are entirely theoretical; the benefits are

very real.

The prize for candid technocrat of the week goes to Erik Sirri,

the director of the SEC’s division of market regulation, speaking

on Thursday at a conference hosted by Vanderbilt University’s Financial

Markets Research Center. The subject is insider trading in the credit default

swap (CDS) market – something which certainly exists,

but which happens to not be illegal, the way the US regulatory system is set

up. CDSs aren’t securities, you see, and so if you trade them you can’t be violating

securities laws.

In any case, Sirri came out and said what everybody in the markets knows but

nobody wants to admit: "In a world of important pricing efficiency,

as it should be."

Sirri then went on to explain that insider-trading laws should still exist,

for the purpose of investor protection. But he added that he thought it "very

important" that credit default swaps be traded – something which

won’t happen if the tradable contracts fall under insider-trading regulations

while the present bilateral contracts don’t.

Alexander

Campbell points out that the problem lies with the ridiculously complex

way in which financial markets are regulated in the US:

Thanks to the fragmented nature of the US financial regulatory system, CDS

abuse could fall through the cracks.

Does fall through the cracks, more like. Whether that’s a bad thing

depends really on whether you’d rather have efficient markets or investor protections,

in a world where "investor protections" are rapidly becoming little

more than full-employment devices for tort lawyers.