Stronger fiber derivatives

Derivatives make the market stronger

First came the news that Greece had entered into derivatives transactions with Goldman Sachs and other banks to hide its public debt. Then came reports that some of those same banks and various hedge funds were using credit default swaps — the type of derivative that kneecapped the American International Group — to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro.

What a mess. The news that Greece had entered into derivatives transactions with Goldman Sachs came in 2003, almost seven years ago. The reports about hedge funds using derivatives to bet against Greece and the euro have already been discredited. And AIG was not brought down because people were buying credit protection on it, it was brought down because it was selling credit protection on subprime mortgage bonds.

I’m conflicted about this editorial, because some of its arguments end up in the right place. But the problem is that it gets to the right destination by using the kind of rhetoric which makes it seem as though the only people who are unhappy about proposed derivatives regulation are the people who don’t understand the derivatives market.

“Because the markets in which they trade are largely unregulated, ” says the editorial, “derivatives can too easily become tools for dangerous risk-taking, vast speculation and dodgy accounting.”

But dangerous risk-taking is actually a good thing, in financial markets. When people engage in risky behavior on Wall Street, they stand to lose a lot of money, but they know that they stand to lose a lot of money, and government doesn’t end up having to step in and bail them out. The big systemic problems happen when leveraged actors think that they’re not engaging in risky, speculative behavior — when banks become complacent about the credit risk in anything carrying a triple-A credit rating, for instance, or when prime brokers are so overconfident with regard to prices moving smoothly and continuously that they unwittingly put themselves on the hook should a highly-levered fund like LTCM suddenly face discontinuous markets.

The editorial continues:

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings. Private markets also lack the rules that prevail in regulated markets — like capital requirements, record keeping and disclosure — that are essential for regulators and investors to monitor and control risk.

This is typical of the piece: it’s largely wrong, and then it’s right. The CDS market is actually more transparent, with smaller bid-offer spreads, than the cash bond market, and the OTC market in interest-rate swaps, for instance, is likewise just as transparent and participant friendly as its exchange-traded counterpart. Moving trading onto exchanges means lower profits for banks, to be sure — because the trading is moved out of the banks’ trading floors and onto the exchanges. But it doesn’t necessarily mean lower trading costs for the buy side: just ask anybody who tries to buy and sell bonds listed on the Luxembourg exchange.

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Yield Hunters' New Tune Echoes Financial Engineering's Past  — Wall Street Journal
And fresh geopolitical angst is again pushing yields lower on benchmark government debt. All this creates incentives for financial engineering.

Popular Q&A

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What are the prospects of a career as an active trader in equity/derivative markets. Inspite of good money making opportunities, very few individuals actually make it as a full time profession. Is it possible to make a career as an active trader? - Quora

Very, very few individuals succeed over the long term (over a "career", essentially) as active traders.  At least one reason for this is that you're exposed to "black swans", which can (and will) periodically wipe you out.  That's just the nature of the equity and especially derivatives markets.  To understand this better, I'd recommend reading Nassim Nicholas Taleb's "Black Swan" and/or "Fooled by Randomness".

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