Derivatives and the Blizzard of Paperwork

Posted by: Matthew Goldstein on May 15

Frank Partnoy, who has been warning about the dangers of derivatives for years, makes some good points in an op-ed in The New York Times about the Obama administration’s plan for re-regulating these esoteric financial instruments. The former derivatives trader-turned-law professor rightly points out that the Obama plan doesn’t go far enough, and might even encourage Wall Street firms to cook-up more abstract derivatives in the future.

How’s that? Well, the administration’s plan only proposes to regulate so-called standardized derivatives—financial instruments that are similiar enough that they can be traded and regulated on a public exchange. The trouble is a large percentage of derivatives are non-standard instruments, which are custom designed by the parties in privately negotiated deals.

For these, one-of-kind derivatives, the administration simply proposes that a record of these transactions be reported to a government agency. But little information about these complex deals will be disclosed to the public. There still will be little transparency for the bulk of the $600 trillion derivatives market.

Simply requiring parties to report these deals isn’t enough to eliminate the potential systemic risk posed the collapse of a major dervivatives counterparty. Says Partnoy: “All derivatives, exchange-traded or private, must be in the sunlight. If institutions want to negotiate individual derivatives contracts, they should tell investors the full details of their exposure.”

Of course, there’s good reason for Wall Street banks, hedge funds and coporate buyers of non-standard derivatives to continue to keep these deals in the shadows. If the public ever saw just how complex and mind-numbing most derivatives are, there very well might be a cry from the public to ban them, or impose even greater regulation.

Andrew Haldane, an executive director for the Bank of England, gave a good illustration of the complexity of some derivatives in a recent speech in Amsterdamn. Haldane pointed out that an investor in a CDO-squared “would need to read in excess of 1 billion pages to understand fully the ingredients” that went into one of these cockamany securities.

I can guarantee that most institutional investors who snapped-up CDOs during the credit boom never bothered to read even 1% of those 1 billion pages of documents. I can also guarantee that most of these investors never realized they needed to read all those documents to fully understand what they were buying.

Maybe if investors understood just how complex a CDO really was, the market for these much maligned securities never would have taken off in the past decade.

Reader Comments

Mark

May 15, 2009 07:07 PM

"The trouble is the vast majority of derivatives are non-standard instruments, which are custom designed by the parties in privately negotiated deals."

Completely false. The vast majority of derivatives -- even OTC derivatives -- are standardized instruments. Maybe 3% of derivatives are bespoke.

This is a non-issue, but if the press keeps claiming that it's some massive loophole or something, then it'll end up undermining the Obama administration's efforts. Be proud, guys.

matt g

May 15, 2009 08:46 PM

mark you make a fair point. i've tweaked the wording a bit, but still would argue some of the most risky derivatives are bespoke deals

sontom

May 15, 2009 09:33 PM

For these, one-of-kind derivatives, the administration simply proposes that a record of these transactions be reported to a government agency. But little information about these complex deals will be disclosed to the public. There still will be little transparency for the bulk of the $600 trillion derivatives market.

GG

May 16, 2009 10:56 AM

Matt G: then you're inter-mixing volume traded vs amount/percentage at risk, and that isn't consistent. As Mark says, the majority of the volume and value in derivatives is in standardized products. The larger risk could be in the custom products, but does it mean "larger" in terms of percentage of the deals in that area, or in absolute value? I would expect that there are still more absolute dollars at risk in the standard derivatives (there is some risk with any instrument), simply because there is so much more in play. I could see the risk as a percentage traded higher in custom product, but without a more information on that, I can't say for sure.

james M. Anderson

May 16, 2009 11:39 AM

When you speak of $600 trillion derivatives market, is that merely some hypothetical number arrived at by the segmenting of some underlying one dollar obligation of some sort or what? What is important, I would think, is the obscene use of leverage for what underlies the real asset being "split up". So, 600 trillion represents how much leverage or dividing of how much of a real asset, money, etc?

matt/bw writer

May 18, 2009 10:09 AM

Hi all. Let me clarify things a bit more. The $600 trillion figure is the notional value based on the value of the underlying assets. Of course with netting the actual potential exposure is much less. if i gave the impression that $600 trillion is at risk--that's my bad. as for the issue of what is more risky--non-standard or standard derivatives. i'd go with non-standard contracts. i wasn't talking about percentages as much as total dollars. but it's a fair point and i'd to get some more specific numbers. but that said, the risk in non-standard derivatives is substantial and so far the regulators don't really seem to have an approach for dealing with them.

Thank you for your interest. This blog is no longer active.

 

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BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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