Credit default swaps, which function primarily as a type of "insurance" are useful, under the right circumstances. The REAL problem is with the private or OTC derivative contracts.
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is unregulated.
All derivative valuation depends on it's "underlying assets", not the instrument itself, or any kind of real ownership of the asset. A word about this stuff - it's not easy to understand... for example, in finance, a forward rate agreement (FRA) is a forward contract (agreement between 2 parties to sell an asset some time in the future) in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e. only the differential is paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs. The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.
Thanks Wikipedia --- Got all that? Me neither, and I have a PhD in economic history. Here's the salient point - According to the Bank for International Settlements, the total outstanding notional amount for ALL these "investments" is $684 trillion (as of June 2008). What? And global GDP is only 53 trillion dollars? Are we getting the problem yet? That's bad enough, but guess what? Two parties can write an OTC derivative contract using ANYTHING as an underlying asset. Anything. Including the weather in Latin America during the agreed time period, or traffic rates on the 405 freeway between Garden Grove and LA, or whether the next batter will hit a single, a double or strike out (just kidding - I'm trying to make a point). This is beyond gambling, this is insanity.
Not only that (but wait, there's more), many different derivative OTC contracts can have many duplicate underlying assets - in other words, say you have 2 OTC's... these 2 discrete contracts can base their valuation on the exact same underlying assets (which let's be honest, are merely underlying conditions, not real assets) without the burden or encumbrance of actual ownership.
Are we tearing our hair out yet?
It should be obvious by now that these products, like any complex financial instrument, can present significant risks if misused or misunderstood. A number of large, well-publicized financial losses over the last few months have focused the attention of the financial services industry, its regulators, derivatives end-users and the general public on potential problems and abuses in the OTC derivatives market. Now, I am no communist, but folks, we need to bring these operations under regulation - that's right, remember I said this $684 Trillion market is unregulated. Let's start out with some simple regs, then ratchet down as necessary, including eligible transactions, eligible participants, clearing, transaction execution facilities, registration, capital, internal controls, sales practices, record keeping and reporting. The release also asks for the views of commenter's as to whether issues described in the release might be addressed through industry bodies or self-regulatory organizations.
Or we can ban them outright... too radical? Maybe. Probably. Needs more thought I guess. One thing is for sure, this unregulated (and practically invisible) $684 trillion market is either the best thing that happened to risk management or it's going to bring down the entire financial system.
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