
How to Fix Wall Street – Madoff’s Law - jasonlbaptiste
http://blogmaverick.com/2009/05/22/how-to-fix-wall-street-madoffs-law/
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ctkrohn
This is an absolutely terrible idea. A couple problems:

1) It creates huge concentrations of counterparty risk. Let's say you're the
firm that invents the credit default swap. For the next five years, you are
the counterparty for every single CDS transaction. If you go bust, the whole
market explodes and everyone is in for a world of hurt. Participants can't
spread their risk around by trading with different counterparties. In the
current environment, we should be doing everything we can to decrease
counterparty risk.

2) What counts as a "new" financial instrument? Let's say it's 2004 and you
want to start selling credit default swaps on asset-backed securities. At that
point, CDS had been around for 10 years and ABS for at least 15. So is CDS on
ABS a new product? Can you get a patent for it? For another example, let's say
it's the mid-80s and you work on the CMO desk. (CMOs, collateralized mortgage
obligations, are a type of mortgage-backed-security where the cashflows from
the mortgages are restructured to better fit investors' demands). Everyone's
doing sequential deals, and you do the first floater/inverse IO deal. CMOs
aren't a new product, but your structure is completely original. Can you get a
patent on that?

3) The products that are at the core of the current crisis weren't really new!
Mortgage backed securities have been around in one form or another since the
late 70s, and credit default swaps were invented in the early 90s. Any patents
would have long since expired.

4) You'd be handing huge profit margins to the bank that invents them. For
traditional physical products, the idea is that this government-granted
monopoly encourages companies to spend time doing capital-intensive R&D which
they wouldn't otherwise consider. But we've seen that banks, hedge funds, etc.
have been willing to innovate without government-granted monopolies. So why
give them a monopoly now?

Ultimately, this isn't much different from software patents. If software
consists of an abstract idea instantiated in code, financial instruments are
an abstract idea instantiated in legal documents and markets. The case against
software patents applies to financial instruments too.

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joshu
Yeah, a monopoly on financial instruments seems ridiculously bad. You need to
construct markets.

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amalcon
This ties into what I like to call the "other gambler's fallacy", wherein
one's visceral understanding of probability tends to exaggerate high
probabilities and underestimate low probabilities. That is, one sees a
probability like 0.001, and ends up treating it as though it were zero.

That said, I'm not sure about the solution the guy proposes. It's basically
patents for esoteric financial instruments. While I don't see anything
inherently wrong with the idea, patents as they are now nominally exist to
speed innovation. This idea is intended to slow the spread of innovations in
one particular area.

In other words, it's possible that this system could develop all the problems
that the patent system has: people would come up with slight variations on an
existing financial instrument so that they could sell it without buying a
license from the creator, or for marketing reasons, or whatever. This would
naturally make instruments more complicated, which in turn makes them harder
to reason about.

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jam
Worthwhile part:

>Call it Madoff’s Law. Where there are consistent returns, it doesn’t mean
that the risk is reduced, it means you can’t see the risk.

Worthless part:

>I would create additional forms of licenses (...) that any financial
institution can apply for (...) and receive for a new financial instrument.

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Dilpil
Yup. Spot on with his analysis of the problem, completely off with his idea
for a solution.

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sharpn
If this extra cost/regulation was enacted it would just move the business
offshore.

