
A Secretive Banking Elite Rules Trading in Derivatives - wallflower
http://www.nytimes.com/2010/12/12/business/12advantage.html
======
tmsh
It's a pretty amazing thing to see a NYT reporter write a five page story
about 'derivatives' and not realize that the people she's talking to are
referring very specifically to CDS derivatives and heating oil derivatives
only.

This was my favorite quote:

 _To get a transparent exchange going, Citadel offered the use of its
technological prowess for a joint venture with the Chicago Mercantile
Exchange, which is best-known as a trading outpost for contracts on
commodities like coffee and cotton._

Right.... First of all, get the name right. It's significantly been called the
CME Group for years now -- and refers to the fact that this is a collection of
all sorts of markets, the vast majority of which are financial derivatives.
Ken Griffin proposed a very specific trading platform for CDS derivatives a
couple of years back. The CBOT and CME (merged as the CME Group) meanwhile
have been trading other financial derivatives, as the majority of their
business, for three decades now.

The key point that is missed in all this imprecision -- is that CDS
derivatives markets are not like other derivatives markets -- which are
regulated. They are contracts that occur between large financial institutions
only. That is the 'secret'. The rest is just the equivalent of a high school
tourist at the visitor's desk.

That said, she's in the general right direction (I won't say ballpark). But
yeah, it's almost like complex businesses require three levels of
understanding that people go through:

    
    
      (1) it's a conspiracy
      (2) it's actually not so bad
      (3) there are targeted ways to improve it
    

Fields shrouded in first-semester textbooks, though mired in specific cases of
catastrophic misuse (financial crisis), I suppose take a little more effort to
get to step 3....

~~~
igravious
I think that most "lay" people would know about the exchange in Chicago by its
old name. It's not like the name change of 2007 is decades ago. And I'm
guessing that CME Group stands for Chicago Mercantile Exchange Group so
referring to the institution as the Chicago Mercantile Exchange is hardly a
howling mistake. And presumably derivatives are a type of contract, and the
derivatives are based on commodities, and oil is a commodity, thus the
reporter seems to be largely right.

Instead of being pedantic and snarky why don't you enlighten us all instead of
using acronyms for everything? CBOT appears to be the Chicago Board of Trade.
But CDS? Is this the famous credit default swaps that helped bring about the
current mess that we are in? And the banks are unwilling to have a light shone
on these dealings. ? What a surprise. She doesn't imply it is a conspiracy -
she actually shows that there appears to be collusion and monopolistic
practices. There is no, "we think they are up to something but don't know
what", it's "they are up to something and aren't playing ball".

~~~
tmsh
_Instead of being pedantic and snarky why don't you enlighten us all instead
of using acronyms for everything?_

Okay, I'll try for a little bit. I should be programming. But a little bit of
history. I apologize for sounding pedantic or snarky.

In the 1900s up until the 1970s, the Chicago Mercantile Exchange (CME) and
Chicago Board of Trade (CBOT) traded mostly agricultural products. A similar
market existed in New York (NYMEX). These exchanges were created so that (as
alluded to in the beginning of the NYT piece) wholesalers, farmers, people
with a heating oil business, etc., could hedge the risk associated with the
price of their commodities (due to weather, circumstance, etc.). Eventually
these contracts became standardized -- they referred to the same # of bushels,
and they were backed by clearing firms and central clearing houses at the
exchange that served as buffer between these hedgers (who would 'hedge their
bet', if they were more interested in selling at a locked in price and not
worrying about the changing prices of the market), and speculators (usually
local traders, or 'locals'), who would assume this risk.

These standardized future contracts fall under the category of 'derivatives',
because they 'derive' from the current price of the commodities (often called
'cash' or 'cash instruments'). It turns out that there is overlap in how you
create other more complex derivatives related to these futures contracts. So
you can create options on these contracts. The options 'derive' from the price
of the futures, etc. Sort of similar to higher order derivatives in math (so
blaming 'derivatives' in general usually irks people in the industry because
that's like blaming 'acceleration').

But there are different cash instruments you can use, and different ways you
can form these instruments. So in the early 1980s, due to tax incentives in
Illinois, and a couple of other reasons, the CME introduces the Eurodollar
future. This is the first major financial future. The cash product here is
interest rates (usually the LIBOR rate -- hence, the 'Euro' -- a standard
short-term interest rate used by banks). So now financial institutions are
starting to see that they can do this same type of hedging of their bets
(they're the 'farmer' or 'heating oil producer' in this equation). If they
want, they can now hedge their exposure to interest rates.

But why stop there? Futures contracts have the benefit of different taxation
(capital gains taxes in Illinois are lower than elsewhere -- I don't know how
much this has changed, but, e.g., this is one of key things a good reporting
piece could focus on -- the justification is that speculation and capital
gains from trading is risky and deserves to be taxed less -- because of the
good to the economy that it provides, etc. -- but I mean, that's worth
debating). And futures contracts also have the benefit that they're
standardized and accessible to anyone with a terminal. So before you know it
futures on stock indicies are introduced (the largest volume contract in the
U.S. -- is the S&P 500 family of futures contracts). And around this time --
in the early 90s, things start to go electronic for the first time.

Bond futures are also introduced (at the CBOT). And this allows large
financial institutions to offset risk more easily with their treasury bond
portfolios, etc.

The key thing here though is that all these instruments, all this financial
futures -- and all the options on financial futures that created -- they're
all regulated. They're all closely watched by the CFTC and other regulatory
bodies.

Enter the problem. Credit Default Swaps. These are non-standardized contracts
drawn up between bulge-bracket firms in New York and insurance agencies to
deal with the risks associated with mortgage securities. This is a huge,
multi-multi-billion dollar industry that isn't regulated because it's still in
its infancy and the participants have never been truly brought into the light.

Financial engineers, having seen how derivative contracts can be used to
offset or control risk -- decide to draft these contracts to deal with
mortgage-backed securities. The problem with mortgage-backed securities -- I
don't know for sure. But I know they've been problematic from the 80s onwards.
The bundling of home loans by New York has just never worked out for everyone
(and Warren Buffett bailing out Salomon didn't fix the core of the problem --
in fact, arguably it glossed it over and left it as a potentially hazardous
situation for two decades later -- though that's highly controversial, and
just my sense -- the rest of what I said is hopefully pretty well accepted).

So creating financial derivatives for CDSes doesn't work in an unregulated
manner. So seeing things collapsing, and seeing an opportunity to be involved
in a huge new market, Ken Griffin proposes that CDSes should be traded in a
more open manner (in 2008). CME Group (which is a merger of all three major
futures exchanges in the US -- CBOT/CME/NYMEX -- another thing a more targeted
reporting piece could focus on -- there's a potential monopoly -- see their
relationship with ELX, etc.), I'm guessing, correctly foresaw that they didn't
want to be anywhere near CDSes with the political backlash coming. So they
wisely turned down his idea. But I could be wrong there -- have no close
familiarity with what really went on.

So that's a little history. I don't know the specifics of the ICE clearing
house conspiracy meeting whatever. But there are hundreds of these 'working
groups' for new types of derivative products. They're traditionally just large
market participants voicing their concerns about how things are going to be
traded (the software involved, the types of contracts, etc.). But...it's not a
conspiracy.... Not any more than ISO / HTML5 working groups are conspiracies
between tech companies to push their interests (I mean there's always going to
be a little bit of that). But these are traditionally actually very good
things -- people coming together to determine how to trade things in the open.

The problem is Goldman Sachs picking up the phone and creating a custom
contract with AIG to insure themselves against a mess of mortgage-backed
securities that they got themselves into. The problem is that (a) they could
trade these to begin (see THE INSIDE JOB, etc. -- for the rationale behind
Glass-Steagall, and the problems with its repeal) and (b) that this didn't
happen in a free, open, accountable market and of course (c) that they got
bailed out because they were so integral to the financial markets to begin
with (which wouldn't happen if part (a) were addressed).

But I mean obviously if you're going to start regulating things more closely,
it's good to figure out exactly what to regulate. But I suppose I really
should get back to programming...

~~~
bd_at_rivenhill
I'll preface this by saying that I work in electronic trading, so I have a dog
in this hunt and my opinion should thus be viewed with some suspicion.

You make two points in the two posts that are related:

 _The key point that is missed in all this imprecision -- is that CDS
derivatives markets are not like other derivatives markets -- which are
regulated. They are contracts that occur between large financial institutions
only. That is the 'secret'. The rest is just the equivalent of a high school
tourist at the visitor's desk._

 _Eventually these contracts became standardized -- they referred to the same
# of bushels, and they were backed by clearing firms and central clearing
houses at the exchange_

In the current state of affairs, the CDS market is not transparent and the
participants who want to avoid transparency point to the custom nature of the
contracts as a reason that they shouldn't be quoted electronically. However,
this situation is similar to what existed in equity/index options before the
products started to be listed by exchanges: customized contracts were traded
through brokers. This sort of OTC trading still occurs, but it exists
alongside a very large, very active market of exchange-traded options whose
prices are very transparent and thus automatically force down the fees that
can be charged in the OTC market because they provide publicly available
pricing information on similar contracts. If electronic exchanges were to
create standardized contract terms for CDSs targeting some of the more heavily
traded debt instruments (sovereign debt be a good target at this point for
obvious reasons) and then list these contracts electronically, I suspect that
this would bring a great deal of transparency to the pricing of these products
due to the participation of firms like Citadel (which already has a large and
profitable group making markets in electronically traded options). Large
players have resisted such transparency in the fixed income markets for years,
and this seems no different.

------
murcielago
I am writing from my "other" account and I make a living in financial
modeling.

While in general the article is true, as always, journalists fudge truth just
a bit to sound more sensationalistic.

> But Mr. Singer wonders if his company, Robison Oil, should be getting a
> better deal. He uses derivatives like swaps and options to create his fixed
> plans. But he has no idea how much lower his prices — and his customers’
> prices — could be, he says, because banks don’t disclose fees associated
> with the derivatives.

Sure there are fees, but most of the premium is the price of risk, the price
of the insurance if you will. While banks sometimes do some proprietary
pricing enhancements, the foundation methods are usually the same and can be
picked from books (like the bible of derivative pricing by John C. Hull) and
papers. I know for a fact that big commodity companies (e.g. oil companies)
have their own financial analysts on staff to double check derivative pricing.
And it is not just that this allows you to haggle with the banks - you do no
want to get derivatives that are too cheap either. That may be a result of
incompetence or a sign of trouble - should the derivative seller pay to you
they will not have enough capital to cover their obligations. That is exactly
what happened with AIG and Lehman Brothers.

Now, Robison Oil may not be that big to have financial analysts on staff, but
they could use third-party pricing consultants, at least.

~~~
pmorici
"proprietary pricing enhancements", that sounds like a scam if I've ever heard
one.

------
stretchwithme
I don't care what the market players do, as long as the taxpayer is not on the
hook when things blow up in their faces. The fact that we are lets them take
dumber risks.

~~~
joe_the_user
You've got to understand that when you create a massively interlocked system
whose collapse would _seem_ likely to bring the entire economy down with it,
you've institutionalized that system's bailout without any laws being passed.

And yes, that lets the risks pile up too.

And no, I don't think the bailout left us better off but the fix was in long
before October 2008.

~~~
stretchwithme
The key phrase is "would seem likely". And it seems even more likely with
people like Hank Paulson claiming that if he doesn't get a slush fund, the
world will end. Even though its really just profits at Goldman Sachs that
would end.

That doesn't mean we can start unwinding things by rolling back the individual
policies that are causing the risky behaviors.

The government could, for example, ensuring only 80% of their bank deposits.
We could start phasing out subsidies for housing by 2% per year. We could let
the market set interest rates.

Of course, the people in charge (regardless of which party) seem to think only
more government interference in the economy could possibly help. They seem
incapable of examining anything they've done or admitting any errors.

~~~
eftpotrm
Or we could recognise that a financial services organisation over a certain
size engagine in certain risky practices is no more inherently safe for
society than a factory dumping toxic waste, and restrict it accordingly.
Sometimes 'big government' creates risk, but sometimes it controls it as well.

~~~
joe_the_user
Yes,

Though one should also look at the number and sophistication of the people a
company deals-with, the amount of leverage it uses and so-forth. But this kind
of analysis isn't really new. It is what central banks are supposed to do. The
Fed's job _was_ "to take away the punch bowl just as the party gets going,"
(<http://en.wikipedia.org/wiki/William_McChesney_Martin,_Jr.>). Unfortunately,
the Fed joined party itself with the repeal of the Glass-Steagel act and we've
had stimulus-through-speculation over the last twenty years. The rise of
speculative excess has a societal and psychological dynamic and once it gets
going it is sustained by the social power achieved by the speculators. The
pattern is old and has ended in grief a number of earlier times in history.

I would recommend <http://prudentbear.com/> and Doug Noland's Credit Bubble
Bulletin. This gives an intelligent analysis of the last twenty years'
speculative excesses.

Also, before tossing out knee-jerk anti-regulation comments, consider how well
Alan Greenspan used this sort of ideology as "covering fire" for the
speculator economy. I'm neutral on whether a libertarian system could be built
soundly from the ground up. But I think it's crucial to note how the use of a
bit libertarian rhetoric to dodge regulations when convenient has been
instrumental in leading us to the unsound ground we are currently on. (I would
admit that Ron Paul's critiques Greenspan's policy actually have been quite
good over the years).

~~~
stretchwithme
One big problem with regulation is how subject to manipulation it is. It
provides a false sense of security to just assume government regulation means
someone is actually writing sensible rules and that someone is actually
enforcing them.

The idea that there is some central intelligence that can decide the soundness
of investments deceives the average investor or saver into thinking they need
do nothing themselves. All the while the government is actively making things
less sustainable and handing out favors along the way.

One could argue that the same is true of private stamps of approval. But there
is competition and many voices out there, each having their own tolerance for
risk.

To have government regulating things is like your brain never having doubts,
never weighing competing concerns except for political ones. And many people
think that way, just going along with the crowd. But we can't afford to have
that sort of thinking govern everything.

~~~
joe_the_user
I agree the government shouldn't be in the business of controlling investment.

But I would just as much note that most people shouldn't have more than a
fairly small percentage of their savings in real, honest-to-god risky
investment. The small investor's chances of being wiped-out are too high and
their being wiped out would, again, have a cost to society not just
themselves.

Thus, the government _should_ supervise a system where most of the average
person's savings go into simple, plodding savings accounts and a fairly small
amount is invested.

This system worked pretty well 1933 ~ 1980. I think Nicholas Taleb also
mentions a similar system.

Oddly enough, a lot of this comes down to the non-Gaussian nature of a
market's expected return. The theoretical foundation of all the schemes for
interdependent, self-insured investment processes assumes the distribution of
market corrections was Gaussian and that thus large corrections would be rare
and multiple investment vehicles would support each other through the law of
large numbers. But with a non-Gaussian, "L-stable" distribution, you simply
can't expect such things.

Government aren't always. Certainly the US government has become more corrupt
on the level of policy over the last thirty years but private industry has
become similarly corrupt (as well as entwined with the state). I'm not sure
what to do here. The state creates monopolies and then

Mandlebrot's essays on finance are very important to look at (along with Hyman
Minsky's theories, etc).

------
pmorici
I saw a good Frontline documentary on this the other day,
<http://www.pbs.org/wgbh/pages/frontline/warning/view/> apparently this whole
mess started back in the 90's and the head of the CFTC then, Brooksley Born,
wanted to put rules in place then to make the derivatives more transparent but
was vehemently opposed by Greenspan, Rubin, and Summers. Turns out that the
current head of the CFTC, Gary Gensler was one of the deputies of the three
guys opposing any regulation of derivatives in the 90's. The three actually
went so far as to get a law passed saying that the CFTC couldn't regulate
derivatives.

Bottom line is anyone that acts surprised by the lack of regulation shouldn't
be because Congress voted on and passed a law specifically prohibiting
regulation of derivatives in the 90's. A law that was promoted by the same
people who now run all the US government agencies like CFTC, Treasury etc...

------
patrickk
Single page:
[http://www.nytimes.com/2010/12/12/business/12advantage.html?...](http://www.nytimes.com/2010/12/12/business/12advantage.html?_r=1&pagewanted=all)

------
fooandbarify
The world of high finance has intrigued me as of late. I recently watched the
documentary "Inside Job" and it made me feel incredibly stupid, so I've set
out to learn what I can about the industry. What an odd little world of its
own.

I can't even say any more than that about the article - it would be like when
my Mom tries to talk about programming. I just thought I'd drop a little plug
for the film here (no affiliation) in case anyone else wanted an interesting
and easy starting point for this stuff :)

~~~
Nrsolis
Inside job is a bit sensationalistic.

That said, you can probably learn a decent amount by reading a book called
"Hedgehogging.". It goes into some of the cultural aspects of finance.

Just keep in mind that "trading" is all about having a better eye for value
than the other guy. In every respect. If you're bad, you'll get fleeced. And
by you, I mean everyone who has placed money with you.

~~~
fooandbarify
I thought it might be. I'd be curious to hear a more balanced perspective on
the crisis, and I suspect part of that will come as I just inform myself about
the industry as a whole.

Thanks for the recommendation - I will be buying _Hedgehogging_ this week if I
can't find it at the library.

~~~
Nrsolis
There are a lot of books on the subject and I've read quite a few of them.

Like most things, different perspectives led different people to arrive at
different conclusions about what led to the crisis.

Put very simply, the folks in charge (traders) were simply allowed to take on
too much risk. And by risk, I mean that they were allowed to borrow money to
make bets on the future value of securities. They believed that most of that
risk was offloaded to a company that could absorb it (AIG) but it turns out
that they couldn't. When everyone found out that AIG couldn't absorb that risk
(defaults on mortgage-backed securities), they ran for the hills (refused to
lend money with mortgage-backed securities as collateral).

Hedgehogging will give you a good idea of the people/mentality that drives
traders and how managing big money works. It's a complicated business and
quite different from your regular mom-and-pop investor. One of the lessons I
took from the book was that being very successful in your fund can lead people
to WITHDRAW their money from your account. It's like they expect you to be
unable to repeat your performance.

Another lesson is that a lot of hedge funds fail. Their fund manager can't get
out of a slump and everyone takes their money out. The fund closes.

But the best lesson is the analogy of fund managers to star athletes. Those
managers that can consistently beat the market are paid very well because they
are making a lot of other people very very rich. That's rare and not a lot of
people can manage it.

------
known
Govt will not take any action because Wall Street is the highest tax payer and
job creator.

~~~
parallax7d
Govt will not take any action because Wall Street floods politician's election
campaigns with dollars so they play ball. If they don't play ball, Wall Street
funds a challenger to the seat.

~~~
igravious
How does Wall St, collectively and en masse decide and go about doing this?
I'm not saying that they don't - I think that it has been fairly well reported
that the sums of money coming from Wall St. as campaign contributions are
large - I would just like to know if there is any coordinated mechanism or is
it a kind of wisdom of the financial crowds ...

~~~
JabavuAdams
Well, it's not that complicated. In a tribe, you help your friends and you
hinder your enemies.

Imagine some techie eating lunch with his techie buddies. Is he likely to talk
about how he's against net-neutrality, or is it likely that he's for it? If he
were against it, he'd seem weird.

Basically, you're not going to screw the people you hang out with all the
time, and might want to work with later.

------
mkramlich
step 1 in their evil scheme: hide all their plans behind a NYT login wall

------
mynameishere
Their lock on the market is less than 100 percent.

<http://tinyurl.com/22pu34p>

