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Dr. Jekyll and Mr. Hyde Finance

About one year ago, AIG was brought to the brink of bankruptcy as a result its exposure under credit default swaps (“CDS”) (a form of credit insurance). Asset backed securities and Collateralised Debt Obligations (“CDOs”), which lived up to its cheery nickname Chernobyl Death Obligation, brought the financial system to the edge of collapse.

Volatile equity and currency markets caused problems with exotic option “accumulators” (known to traders as “I-will-kill-you-later”). Numerous investors and corporations are bunkered down with their lawyers hoping to litigate their way out of significant losses on “hedges” pleading familiar defenses – “I did not understand the risks” or “I was misled about the risks by the bank”.

If you assumed that these events meant that wild beast of derivatives would be tamed, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (“LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.

Tried and faied initiatives (based on particular religious convictions) will be prompted including improving disclosure, increasing capital and implementing a new centralised counterparty (“CCP”) to attemnpt to reduce the risk of a major dealer failing. Fundamental issues - the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems - will not be substantively addressed.

The industry and its key lobby group (ISDA – International Swaps & Derivatives Association) are well practiced in the art of regulatory skullduggery.

Derivatives, it will be argued, are 'soooo' complicated that only derivative traders themselves can properly “regulate” them. If this fails then there will be more subtle rhetorical thrusts.

The new CCP is only for “standardised” derivatives. Already, there are impassioned semantic debates about what is meant by “standard derivatives” and whether they can actually be cleared through the CCP.

On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: “Not all standardized contracts can be cleared.” He argued that that even if they have standardized economic terms many derivatives contracts will be “difficult if not impossible to clear” because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make “it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.”

Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that “it may be more appropriate for products that trade less frequently to trade over-the-counter.”

The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.

The reasons for policy inaction are complex. As undoubtedly numerous professors from well-known universities will testify, derivatives do perform important risk transfer functions within modern capital markets – the Dr.Jekyll side of derivatives. ISDA’s Pickel laid out this argument with eloquent panache arguing against standardisation and the CCP as it “would undercut their very purpose: the ability to tailor custom risk-management solutions to meet the needs of end-users.”

Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.

The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.

For banks, the Dr.Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.

The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must “innovate” to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious “profits” that their bonuses are based on.

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 all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is a buck to be made in the trade.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).