Toward Transparent Derivatives Trading

Could you describe the financial crisis in a sentence? Margaret Atwood’s description (in Payback: Debt and the Shadow Side of Wealth) appears to me as good as any:

[This] scheme. . . boils down to the fact that some large financial institutions peddled mortgages to people who could not possibly pay the monthly rates and then put this snake-oil debt into cardboard boxes with impressive labels on them and sold them to institutions and hedge funds that thought they were worth something.

I’d only add one amendment, to recognize the last step in the agency problem: the products were sold by and to institutions whose managers believed that they could still pocket fees and bonuses without being liable to principals for gross malfeasance. As the former head of AIGFP enjoys his fortune, the joy in passing on the proverbial hot potato must daily bring a smile to his face.

As these black boxes continue to blow up, the WSJ Opinion page recently featured a proposal to open up some of them. Professors Viral Acharya and Robert Engle argue that “derivative trades should all be transparent,” in refreshingly plain English:

Most financial contracts are arrangements between two parties to deliver goods or cash in amounts and at times that depend upon uncertain future events. By their nature, they entail risk, but one kind of risk — “counterparty risk” — can be difficult to evaluate, because the information needed to evaluate it is generally not public. Put simply, a party to a financial contract might sign a second, similar financial contract with someone else — increasing the risk that it may be unable to meet its obligations on the first contract. So the actual risk on one deal depends on what other deals are being done. But in over-the-counter (OTC) markets — in which parties trade privately with each other rather than through a centralized exchange — it is not at all transparent what other deals are being done.

This makes it likely that some institutions will build up excessively large positions in OTC derivatives without the full knowledge of other market participants. If these institutions were to default, their counterparties would also incur significant losses, creating a systemic risk.

Acharya and Engle criticize Treasury Secretary Timothy Geithner’s proposed new regulations on derivatives trading for not going far enough to address these issues. I’m not surprised at their inadequacy, but I think Acharya and Engle may underestimate the growth of secrecy as a linchpin of contemporary capitalism. Trade secrecy is a key part of the business practices of all manner of middlemen, ranging from search engines to health insurers. We can debate its utility in those fields. But it appears totally out of place where a Gordian knot of gambles can put the entire global financial system at risk. Trade secrecy has little or no place in a financial world wrecked on the shoals of black box derivatives trades and an opaque “shadow banking system.” As Stephen Mihm has noted,

The drumbeat of bad news . . . is [according to many experts] only a symptom of something new and unsettling – a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools. That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade – a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.

Even if the Acharya and Engle proposal is deemed too extreme by team Geithner/Summers, it would be inexcusable not to have some group within the SEC given this information in real time. Think of it as a FISA court for finance.

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