Streambase

Still Stressed After All These Tests!

For the second time in two years, the European Banking Authority (“EBA”) completed tests on European banks to demonstrate their “solvency” under conditions of “stress”.

The results have been over shadowed by other momentous events - the announcement by the European Union (“EU”) of a range of measures to deal with the European debt crisis. The tests remain highly relevant as the EU measures are unlikely to “resolve” the debt problems and European banks remain heavily exposed to losses. The risk of a European banking crisis remains.

Last year’s debut test was openly derided as the equivalent of conducting a crash test on a motor vehicle assuming that the car could never crash. Within months of the stress test, several Irish banks that had passed needed rescue by the EU and International Monetary Fund (“IMF”). Another major casualty was the credibility of European Banking regulators.

For the record, only 8 out of 90 European banks tested “failed” the 2011 test, meaning that they did not have the required 5% level of capital in a stressed scenario. Their capital needs were estimated at around Euro 2.5 billion. Another 16 banks were deemed vulnerable, being within 1% of the minimum required capital level. The numbers are eerily similar to that in the first stress test, which passed all but seven of the 91 banks tested identifying an aggregate capital shortfall of only Euro 3.5 billion.

In another similarity to the original stress tests, all those who “failed” were small banks. The 2011 tests did show that some large banks, including Deutsche Bank in Germany, UniCredit in Italy and Société Générale in France, had capital reserves close to the minimum level where they would have formally been required to raise more capital or reduce risk.

Highly stage managed and contrived, the latest stress test has done little to build confidence, instead exacerbating uncertainty and doubt.

The coverage of the stress tests is not comprehensive covering around 60-70% of the European banking sector, with many small banks being excluded. After the 2011 test, two small Danish banks, who had not been tested, failed. While their assets were minor, the ability of a small bank failure to affect other larger banks in a chain reaction remains a concern.

During the 2011, one bank - Helaba – withdrew, taking issue with the definition of capital. The level of coverage reduces the utility of the test and the value of the information disclosed.

The test focused on the effects of weaker economic growth, falls in stock and property prices, increases in funding costs and, most topically, losses on sovereign debt holdings. A well recognised problem is that the tests were really not “stressful” enough. The most significant deficiency was in relation to bank holdings of sovereign debt.

Where sovereign bonds were held in the banks’ “banking books” (generally long term, non traded investments), a credit rating downgrade of the issuer was specified – 4 notches for a country rated BBB, or lower, 2 notches for a country rated AA/A. For Greek bonds, this translated into a stress scenario of 15% loss. This was below the actual market losses of 50-60% implied by current market prices for Greek bonds or the 21% loss where banks roll over Greek debt under the new bailout package proposed. Similar problems exist with the Irish and Portuguese bonds where market prices imply losses around 30-40%.

Unlike the previous stress test, sovereign bonds held for sale in the bank’s “trading books” were included. The test implied losses from widening credit margins of around 20-30% for Greek bonds, with lower losses for Ireland and Portugal. For Spanish and Italian bonds, the losses were more modest, below the levels seen in recent trading.

The test results may significantly underestimate losses if Greece, Ireland and Portugal default and the Spain and Italy experience serious financial pressure. Traders joked that they would have “mark-to-market” profits if the stress test standards were used to revalue their holdings.

Other stress elements, while less controversial, were also insufficiently testing. The modest drop in growth and rise in unemployment contrasts with the sharp contraction in economic activity and employment seen in the peripheral European economies. Given the stated desire of the EU to bring public finances and budget deficits in line with guidelines, the risk of a long period of stagnation – low growth and high unemployment – and its effect on loan losses cannot be discounted.

The use of consistent parameters across Europe is questionable. Country-by-country credit data disclosed by the stress test reveals the fragility of some economies. For example, in Spain, British banks disclosed default rates of 8-9% on their credit portfolios. In Ireland, one British bank suffered defaults totalling Euro 13 billion on a total credit portfolio of Euro 64 billion – a rate of loss of around 20%. Standard stress conditions unadjusted for specific national conditions are analogous to achieving an acceptable average ambient temperature by placing one’s feet in the oven and head in the refrigerator.

The assumption of a 15% fall in stock prices may understate potential volatility. The 10-17% fall in property prices looks benign. For example, Spanish property prices remain elevated, well above trend. The overvaluation is exacerbated by unwillingness on the part of lenders to take possession of and sell assets securing loans, which would realise losses.

The interaction of the individual stress factors, the so-called “knock on effects”, are crucial. In the first phase of the global financial crisis, major problems were caused by negative feedback loops starting with loan losses, distressed banks, freezing up of money markets, cessation of lending and macro-economic effects (reduced growth, higher employment, slowdown in trade) which then set off new cycles of instability. The non-incorporation of “second order effects” is a serious deficiency.

A more egregious problem is that it was perhaps the wrong kind of testing on the wrong parties and issues.

Financial systems rely on the implicit support of national banking systems by the sovereign. As highlighted by the global financial crisis (“GFC”), financial institutions are “too big too fail.” This assumes the ability of sovereigns to support their banks, should it become necessary. The financial distress of many Euro-zone countries is well documented. These sovereigns are in no position to support their banks. A stress test of European banks is meaningless without a parallel assessment of the ability of the sovereign to support the bank.

This affects the access of banks to capital or liquidity. The stress tests merely identify the need for capital. Banks must raise capital from the capital market or governments, as was necessary during the first phase of the GFC. Given that a troubled bank may face difficulty accessing capital from investors, the ability of the governments to supply the necessary capital is crucial.

No one seriously believes that European banks need a mere Euro 3.5 billion of additional capital. Rating agency Standard & Poor’s estimates that European banks need around Euro 250 billion of additional capital to withstand a sharp economic downturn. Using a stricter 7% capital target and adjusting for losses on sovereign debt in banking book, JP Morgan research analysts believe that around 20 banks would need to raise capital. UK banks would have tor raise around Euro 25 billion, French banks Euro 20 billion and German banks Euros 14 billion. The ability of national governments to provide banks with the required additional capital remains unknown.

The stress tests also focused on the banks’ assets. The trigger for bank problems is usually the inability to finance themselves in the money markets – the “run on the bank”.

The funding difficulties of certain European banks are well known. Greek, Irish, Portuguese, Spanish, smaller Italian and smaller German banks currently have limited access to international money markets.

Covered bond issues, a traditionally reliable means of raising funds, have had to be cancelled. Some European banks have abandoned financing plans in the US and Asia in the face of nervousness in money markets.

Many banks, especially in the troubled peripheral sovereigns, are now dependent on funding from their own central bank or the European Central Bank (“ECB”). According to market estimates, the ECB has provided up to Euro 400-450 billion in financing, including Euro 240-250 billion to the bailout nations. Much of this financing is against collateral of uncertain value, being government bonds including those issued by the beleaguered sovereign. Some stronger national central banks, according to some studies, may have also advanced Euro 450 billion to other central banks within the Euro-zone to assist with financing banks with liquidity problems. The Bundesbank’s share of this financing is over Euro 300 billion.

The stress tests did not assess the banks’ ability to withstand continued funding pressures. The EBA glibly noted that it was “aware of the funding liquidity challenges in the current environment and national authorities are taking steps to extend maturities, increase buffers and develop contingency plans.”

Facing criticism about the rigour of the tests, the EBA pointed to the disclosure of financial information which enables banking analysts to conduct their own review. The volume of data is impressive - 91 banks; 3,200 data points per bank; 10 pages of disclosures per bank. Unfortunately, the information provided is filled with anomalies, mainly relating to aggregation of data and omissions.

For example, one British bank only disclosed the European credit exposures in its UK operation, omitting exposures held through other entities below the 5% EBA disclosure threshold. One Italian bank did not separately disclose Eastern European exposures, as they were held via their subsidiary in Austria.

The stress tests are revealing about EU and European banking sensibilities. The design of the sovereign bond tests highlights the underlying politics and semantics. The use of the rating agency methodology (4 notch downgrade) allowed the EBA avoided the use of the “banned” terms - “default” or “haircut” on sovereign bonds.

Europe seems unable to grasp the seriousness of the situation and deal honestly with its financial problems. There are media suggestions that the EBA preferred a stronger stress test but was constrained by political and banking pressures. There were even suggestions that national central banks failed to provide EBA with accurate data. The UK Telegraph quoted the EBA Chairman saying that: “figures given by the banks in some cases ‘materially’ changed after being challenged”.

Bankers resisted disclosure arguing that given the uncertainty in money markets, release of detailed information would exacerbate the crisis. The answer, argued bankers, was to reduce the level of detail significantly.

The stress test’s objectives were laudable: (1) to strengthen the financial system by forcing banks to hold adequate equity, and (2) to convince markets about the solvency of European banks. Unfortunately, the deep flaws of the stress test mean that they failed both objectives. The market’s judgement was quickly evident. Straight after the release of the test results, Italy’s Intesa Sanpaolo and Spain’s BBVA, who emerged from the stress test with core tier one capital of more than 8% - a top rated “pass”, saw their shares fall sharply.

When the expected European sovereign debt restructurings occur and the effects on the real economy become evident, European banks and regulators will still need to pass the only test that really matters. Whatever the stress tests say, the real test still lies ahead. Given events of recent days - perhaps sooner than most people think.

© 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (due to be published in August 2011)

Derivatives Regulation Dance - Part 2

A question of values …

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.

Model variations and small differences in input can frequently result in large changes in values for some products.

The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.

For example, a key assumption of derivative valuation is that a transaction can be hedged with a counterparty or through other means at all times. In late 2008, in the aftermath of the collapse of Lehman Brothers and problems at AIG, market liquidity dried up and made it impossible to source market prices or transact in many instruments.

The model-based valuations are used to determine earnings and ultimately bonus payments for dealer staff. In Warren Buffet’s inimitable words this allows the dealer to see “… where the arrow of performance lands and then [paint] the bull’s eye around it”.

The accuracy and tractability of derivative valuation, especially for complex products, is questionable.

MtM prices may be also prone to manipulation. Recent disclosures about events leading up the government bailout of AIG highlight potential problems.

There is limited internal or external (auditors and regulators) oversight of the models. This reflects, in part, the complexity of the models and the scarcity of experienced professionals capable of undertaking such reviews.

Widespread reliance on models and MtM methodology is perhaps surprisingly an unquestioned article of faith in financial markets. It allows immediate recognition of gains and losses that will accrue over many years immediately. After his purchase of Gen Re and discovery of the problems surrounding its derivatives operations, Buffett remarked: “I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably they have favoured the trader who was eyeing a multi-million dollar bonus … Only much later did shareholders learn that the reported earning were a sham.”

Current regulatory proposals do not attempt to deal with the pricing, valuation and model issues. As Daniel C. Gelman observed: “Where secrecy reigns, carelessness and ignorance delight to hide.”

Stand by Me …

In derivative contracts, each party takes the credit risk of the other side in terms of performing their obligations. This is known as counterparty risk. The failure of Lehman Brothers and a number of banks during the Global Financial Crisis (“GFC”) highlighted the problems of counterparty risk in derivatives.

Counterparty risk is complex because the payment obligations between the parties are contingent. The quantum and the direction of payments depend on market price movements. The potential counterparty risk is not known in advance and is apparent only when actual price movements occur. In practice, this requires parties to estimate the potential exposure using mathematical models based on the expected evolution of the relevant market prices.

Over the last two decades, the derivatives market has becoming more democratic. Entities with lower credit ratings have become active users of derivatives. This includes highly leveraged investors, such as hedge funds and private equity funds. Participation of these riskier entities has entailed reliance on credit enhancement techniques.

The primary form of credit enhancement is the use of bilateral collateral. This entails counterparties posting collateral in the form of cash or high quality securities to secure the current value of the contract. The collateral acts as surety against non-performance under the contract. Collateral arrangements are highly customised. For example, AIG’s collateral arrangements required the firm to post collateral only where the exposure under the contracts increased above an agreed level or AIG’s credit rating was reduced below a specified quality.

Counterparty risk and credit enhancement techniques are predicated on the same models used for pricing and valuation. Use of bilateral collateral relies on the accuracy of valuations and risk models. It also relies on certain and enforceable legal rights in respect of collateral and proper management of the cash and security lodged.

The GFC, especially the bankruptcy filing of Lehman Brothers, provided a test of counterparty risk in derivatives. The quantification and management of such risk proved problematic. The quantum of credit risk from derivatives was higher than model based estimates as market volatility increased and correlations between risk factors moved erratically. Legal enforceability, control and management of collateral also experienced problems.

Current regulatory proposals focus heavily on counterparty risk issues. The central legislative reform proposed is a central clearinghouse - the central counterparty (“CCP”). The BIS also proposed changes in capital requirements against counterparty risk in the light of recent experience.

Under the CCP arrangements, “standardised” derivative transactions must be transferred to an entity that will guarantee performance.

The CCP implements risk management systems to manage its exposure under derivative contracts. The CCP will be reliant on risk models and the ability to value contracts. As noted above, there are significant issues in pricing and valuing contracts and, for some products, reliance on complex models.

The CCP proposal relies heavily on “self-confidence”, which as Samuel Johnson observed is “the first requisite to great undertakings.” In relation to the CCP, legislators and regulators are basing their approach on Lillian Hellman’s helpful advise: “It is best to act with confidence, no matter how little right you have to it.”

One (Not Very Nice) World…

The GFC, in line with previous derivative crises including the collapse of Long Term Capital Management (“LTCM”), revealed deep fault lines in financial markets.

Derivative markets entail complex chains of risk that link market participants. This is similar to the re-insurance chains that proved problematic in the case of Lloyd’s Insurance market problems. In both markets, the risks are both potentially significant and “long tail”, that is, they do not emerge immediately and may take some time to be fully quantified.

Current regulatory proposals have not focused on the issue on inter-connected trading and concentration risk other than as a by-product of the CCP proposal. It is widely believed that the CCP will improve the market structure.

In reality, the CCP becomes a node of concentration. The CCP may also increase concentration risk. The heavy investment required to establish the infrastructure to clear contracts through the CCP will mean that a few large derivative dealers will quickly dominate the business. In addition, to the extent that products are not routed or counterparties are not obligated to trade through the CCP, the problems remain and may increase.

A central problem of the current derivative markets is potential liquidity (cash or funding) risks. Ironically, the problems derive, in substantial part, from the desire to reduce counterparty risk through credit enhancement procedures, such as bilateral collateral.

Where derivative contracts are marked-to-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses.

AIG’s CDS contracts were subject to the provision that if the firm was downgraded below AA- then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be around US$14 billion. AIG did not have the cash to meet this call and ultimately required government support.

Current regulatory proposals do not address liquidity risks in derivative markets. Interestingly, the CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources.

Failed Plumbing…

The GFC has exposed long standing and significant problems with the infrastructure of derivatives markets.

In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.

Derivative systems and trade processing are generally inadequate, with infrastructure lagging well behind innovation. Delays in documenting contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.

Current regulatory proposals seek welcome improvements processes and systems for derivative trading.

Derivative contracts are documented under the International Swap and Derivatives Association (“ISDA”) Master Agreement. The ISDA Agreement has been remarkably successful in standardising documentation of trading.

The contract has not been tested under stressful conditions such as those of the GFC. A number of issues have emerged.

The bankruptcy of Lehman Brothers and resulting unwinding of complex derivative arrangements has exposed problems of derivative and bankruptcy law, especially in cross-border, multi-jurisdictional transactions. The GFC also exposed issues relating to the documentation of specific derivative contracts, such as CDS contracts, and the impact on bankruptcy and resolution of financial distressed firms.

Current regulatory proposals do not address any of these documentary issues.

Bank regulatory capital has long distinguished between banking (loans or hold-to-maturity assets) and trading books (trading or available-for-sale assets). Differing capital rules between the banking and trading books encouraged regulatory arbitrage, generally using derivative structures to reduce the required level of capital. The BIS has addressed some regulatory anomalies, increasing the capital required against derivative positions.

Regulatory initiatives continue to emphasise improved disclosure of derivative contract. There is already significant disclosure, although much of it is incomprehensible and lacks utility. Additional disclosure will not significantly reduce systemic risks of derivatives.

Regulatory initiatives do little to address the quality of regulators and the acuity of oversight. The absence of suitably expert and experienced regulators will undermine regulatory and legislative initiatives. Given the shortage of talent in derivatives generally and the pay grades of regulators, it will be difficult for regulatory agencies to properly supervise dealers and derivative activity. In terms of an old Spanish proverb “Laws, like the spider's web, catch the fly and let the hawk go free.”

Regulatory Tango…

Debate over regulation of financial services has taken on a frenzied tone.

Regulatory agencies are jockeying for position, sometimes forming unlikely coalitions to preserve or expand territory. The Commodity Futures Trading Commission (CFTC), under Chairman Gary Gensler, has been a staunch champion of regulation, including the CCP. The CFTC, which would share oversight of derivatives trading with the SEC, will require 119 new employees and a $45 million budget increase to $261 million. Interestingly, its hiring focus is on rule-making attorneys with a minimum five years’ legal experience for “drafting especially lengthy and difficult rules and regulations implementing new legislation.” With a starting salary of $145,000, it will be interesting to see if the CFTC attracts candidates with the requisite skills. More interestingly, the CFTC clearly feels that what regulation needs is more lawyers and more rules.

Consultation with industry participants is unlikely to result in progress. As Wolfgang Schäuble, the German finance minister, told the Financial Times: “If you want to drain a swamp, you don’t ask the frogs for an objective assessment of the situation.”

Banks and their lobbyists do not believe that there is a case for regulation. In William Davenant’s words: “Had laws not been, we never had been blam'd; For not to know we sinn'd is innocence.”

Groucho Marx observed that “[government] is the art of looking for trouble, finding it, misdiagnosing it and then misapplying the wrong remedies.” Legislators and regulators are likely to discover the truth of that proposition in their attempts to regulate the derivative market.

© 2011 Satyajit Das All Rights reserved.

Satyajit Das is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010).

Derivative Regulation Dances - Part 1

On 30 July 1998, Alan Greenspan, then Chairman of the Federal Reserve argued that: “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” In October 2008, the now former Chairman grudgingly acknowledged that he was “partially” wrong to oppose regulation of credit default swaps (“CDS”). “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing. His current views on wider derivative regulation remain unknown.

Politicians and regulators globally are currently busy drafting laws to regulate derivatives. A common theme underlying the activity is an absence of knowledge of the true operation of the industry and the matters that need to be addressed. As Goethe observed: “There is nothing more frightening than ignorance in action.”

The author Thomas Pynchon warned: “If they can get you to ask the wrong questions then the answers don’t matter.” Simplistic causes and solutions may prevent real issues in relation to derivatives from being debated and dealt with.

Size Matters …

Based on surveys conducted by the Bank of International Settlements (“BIS”), the global derivative market as at June 2009 totalled US$605 trillion in notional amount. This is a large increase in size from less than US$10 trillion 20 years ago. The bulk of the activity takes place in the Over-the-Counter (“OTC”) market where derivatives are traded privately and on a bilateral basis between banks and clients. The OTC market should be contrasted with the exchange traded market where relatively standardised products are traded on formalised, regulated exchanges.

The outstanding amount compares to global Gross Domestic Product (“GDP”) of around US$ 60 billion. As author Richard Duncan points out in his 2009 book The Corruption of Capitalism, the outstandings in the global derivatives market at its peak in June 2008 (US$760 trillion) was equal to “everything produced on earth during the previous 20 years.”

Volume estimates are affected by double and triple counting and other statistical problems. There are also significant disagreements about the significance of the size numbers.

Derivative professionals argue that derivative notional amounts (the face value of the contract) are a stock measure (like assets and liabilities). GDP is a flow measure (i.e. income). So strictly speaking they are not directly comparable.

Derivative professionals also argue that the outstanding value is irrelevant as it is only the notional face value of contracts. They focus on the current value (around US$25 trillion) that can be further reduced after netting between dealers to around US$4-5 trillion. If the US$4 trillion in collateral (cash and government securities) held to secure the current value is considered, then they argue that the exposure is a negligible amount.

In effect, there is no risk. The size of the market doesn’t matter. As Laurence J. Peter author of the famous Peter Principal stated: “Facts are stubborn things, but statistics are more pliable.”

Current value is a calculation of the worth of the derivative contract if terminated today. It provides a useful measure of current price and risk.

The notional amount represents the actual amount of underlying assets that the trader is exposed to. The notional face value is the essential starting point of market size and any measure of leverage. The size of the market is inconsistent with the thesis that derivatives are merely a vehicle for hedging and risk management.

Current regulatory proposals do not attempt to deal with the size of the derivatives markets. The current debate about “too big to fail” banks may indirectly affect the size issue.

Approached to provide government aid to a company that claimed it was to big to fail, Richard Nixon advised: “get smaller!” Derivative regulators would do well to heed Nixon’s advice.

Grand Speculations…

Proponents argue that derivatives are used principally for hedging and arbitrage. In this way, they perform an economically useful function aiding capital formation and reallocating risk to those willing and better able to bear them. While they can be used for this purpose, derivatives are now used extensively for speculation, that is, manufacturing risk and creating leverage.

Stripped of quantitative hyperbole, derivatives enable traders to take the risk of the asset without the need to own and fund it. For example, the purchase of $10 million of shares requires commitment of cash. Instead, the trader can instead enter a total return swap (“TRS”) where he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return and risk through leverage.

Derivative volumes are inconsistent with pure risk transfer. In the CDS market, volumes were in excess of four times outstanding underlying bonds and loans. In the currency and interest rates, the multiples are higher.

Investors searching for return drive speculation. Concerned about stagnant real incomes and inadequate retirement savings, individual investors seek out higher yielding investment structures, often based on derivatives. Pension funds and other institutional investors use derivatives to enhance returns to fully fund and meet their contracted liabilities. In an environment of diminishing returns and fierce competition for attractive investments, fund managers use derivative strategies to enhance returns through readily accessible leverage and capacity to create risk “cocktails”.

Facing increased pressure on earnings, corporations have increasingly “financialised”, resorting to speculative derivative trading to meet profit expectations.

This pattern affects small companies as well as large companies. It is also evident in emerging as well as developed economies. In China, India and Korea, companies resorted to aggressive derivative strategies to augment earnings as profit margins on products were relentlessly forced down by competition and buyer pressure. Some strategies have led to significant losses.

The competitive advantage, if any, enjoyed by investors and corporations in speculative trading, especially in complex derivatives is unclear. Perhaps it is a lack of “horse sense” which as stated by Raymond Nash is “what keeps horses from betting on what people will do.”

Proponents argue that speculators facilitate markets and bring down trading costs, thereby helping capital formation and reducing cost of capital. There is little direct evidence in support of this proposition. Recent experience suggests that in stressful conditions speculators are users rather than providers of scarce liquidity.

Given derivatives are second order instruments deriving its value from underlying assets, the argument regarding liquidity is curious. In many cases, the derivative contract is far more liquid than the underlying debt, shares, currency or commodity. This is consistent with trading in derivatives having a significant non-hedging, speculative element.

Speculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies.

A reduction in speculative activity would also arguable free up capital tied up in trading. This capital could be deployed more effectively within the economy.

Control of speculative activity in derivatives is feasible. This would require traders to show an underlying risk as a pre-condition to entering into a derivative contract. In the case of investors, it would also require the derivative contract being covered fully with available cash or other securities.

The concept is used extensively in the insurance markets. A similar concept is embedded in the hedge accounting standards currently in use.

Current regulatory proposals do not attempt to deal with speculative activity directly in the derivatives markets. Some U.S. insurance regulators have proposed controls on speculative activity in certain derivatives, such as CDS, by requiring an underlying position.

Amusingly, dealers now argue that the bulk of trading activity is actually for hedging purposes. It may have something to do with a more elastic definition of “hedging”. No evidence was offered. Dealers were probably following Mark Twain’s advice: “Get your facts first, and then distort them as much as you please.” In reality, probably no more than 10-20% of activity in the derivative markets is related to hedging.

The Obama Administration’s proposed “Volcker Rule” prohibiting major banks engaging in proprietary trading may, if implemented, affect speculative activity in derivatives. In the surreal theatre of U.S. regulation, the Senate Committee on Agriculture, Nutrition and Forestry, chaired by Blanche Lincoln, has introduced its own version of regulations. The controversial Section 106 prohibits banks using swaps from accessing the Fed’s discount window.

The proposal would prevent banks from hedging their own exposures using swaps as well as trading swaps. At a minimum, it would force banks to move their derivatives activities into non-bank entities. Transferring such activities would require additional capital (estimated at $20 billion or more) and also result in higher cost of funding for the derivatives activities. It is not clear how this proposal actually addresses any of the fundamental issues relating to derivative activities.

Spoilt for choice…

Relatively simple derivative products provide ample scope for risk transfer. Standard forwards or options will generally complete markets and provide the ability to manage risk. The proliferation of complex and opaque products is prima facie puzzling.

In the 1950s, two economists, Kenneth Arrow and Gerard Debreu, proposed a theoretically perfect world - known as the Arrow-Debreu theorem. To attain the nirvana of economic equilibrium, the theorem required there to be securities for sale for every possible state of the future – “state securities”. There should be contracts to buy or sell everything at any time period in every place until infinity or the end of the world, whichever was first. This utopian worldview provides the justification for allowing any and every type of derivative markets to be created.

Dealers argue that such structures are created in response to customer demand and to provide “financial solutions”. In my experience, clients rarely ask to be shown a US$/ Yen big figure stop with double-barrier conditional accumulator (with or without Elvis Presley pelvic thrusts). Complex structures are designed and sold (often aggressively) by dealers.

The major drivers for complex products are increased risk and leverage. Some structures are also designed to circumvent investment restrictions, bank capital rules, and securities and tax legislation.

A key issue is the use of “embedded” leverage. These arrangements are used to provide leverage to investors and corporations whose internal or statutory rules prevent borrowing to finance increased investments. Derivative technology is deployed to increase gains and losses for a particular event (such as a change in market prices of an asset) in accordance with customer requirements to provide the effects of leverage without transgressing their investment mandates.

Proposals to control bank leverage, in broad terms, lack understanding of the issues of embedded leverage and its use in financial markets.

Complexity is also related to profitability of derivative trading. On 19 March 1999, Alan Greenspan speaking at the Futures Industry Association Conference at Boca Raton, Florida remarked: “… the profitability of derivative products has been a major factor in the dramatic rise in large banks’ noninterest earning and … the significant gain in the overall finance industry’s share of American corporate output… the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.”

The former Fed Chairman’s statement showed an alarming lack of understanding of the real sources of derivative trading profits. Many financial products are opaque and priced inefficiently to produce excessive profits – economic rents – for dealers. Efficiency and transparency is not consistent with high profit margins.

The majority of derivative transactions are standard and “plain vanilla” earning low margins with dealers relying on volume for profits. The bulk of dealer profitability comes from a few complex products. They also feed trading in standard products as dealers manage and re-allocate their risk from more structured transactions.

Complexity is also related to mis-selling of derivative products. Arcane structures create significant information asymmetry. Mis-selling of “unsuitable” derivative products to investors and corporations remains a problem. Expertise of purchasers is sometimes inversely related to the complexity of derivative products.

Currently, there are numerous disputes concerning derivative transactions between banks and their clients at various stages of litigation and a significant source of earnings to litigation lawyers. It is difficult to identify the causes – client greed or ignorance versus dealer greed or misrepresentation.

Current regulatory proposals do not deal with the issue of complexity in derivative products. Regulators could have forced standardisation and listing of derivative contracts, only allowing them to be traded on exchanges. They have favoured, probably correctly, the need to customise products and structures for users and their needs.

In relation to product suitability, the BIS have proposed “pharmaceutical” style warning systems, which do not address the problem. Given significant information and knowledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should be considered.

Such proposals are likely to be unacceptable as inconsistent with “freedom of choice”. “Free market” advocates are likely to side with the view of an anonymous commentator: “Nine out of ten people who change their minds are wrong the second time too.”

© 2011 Satyajit Das All Rights reserved.

Satyajit Das is the author of Extreme Money: The Masters of the Universe, Financial Alchemy and the Cult of Risk (forthcoming) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010).