Risk Markets And Politics

Monday, October 13, 2008

Disneyland burned down

Satyajit Das, in his 2006 book:

Dealers on exchanges charge clients a fixed commission to trade; the cartel of dealers means that clients have no choice other than to deal through them. The dealers are fierce advocates of competition except where it affects them.

In the OTC markets, dealers are more creative — they ensure that the clients do not know the true price of what is traded. The lack of transparency lies at the heart of derivatives profitability. You deny the client access to up-to-date prices, use complicated structures that are hard for them to price, and sometimes just rely on their self-delusion.

In the late 1990s, I was visiting Mumbai. The stock exchange was debating a move to electronic trading, but there was resistance. They invited a Nobel-Prize-winning US financial economist to speak at the conference, seeking to win over brokers to electronic trading. The economist spoke eloquently and movingly of 'greater trading efficiency', 'lower transaction costs' and 'greater pricing transparency'. The audience was almost in tears — of laughter.

It's one thing when opaque markets allow dealers to disguise trading costs. Our traders in Mumbai knew that to be a real source of profits, and one that would merely bleed their clients. More insidiously, opacity allows losses to be mis-represented. Before even considering the shortfalls of the Gaussian, it's obvious that the surest way to deliver a shocking tail move to the market is to just not mark (that is, mis-mark) prices. It's not clear to what extent the meltdown was actually a failure to predict as opposed to the result of skewed incentives and conflicts of interest along the chain beginning with mortgage origination and ending with the shareholders, who may have not even realized that they were in the security warehouse business. The models and the rating agencies gave the "right" answers, but who thought they were the correct ones?

In any case, the market thinks that public exchanges and clearing companies are among the winners. It was only a few months ago that the DOJ questioned the legality of exchanges such as CME operating clearing businesses. There is little doubt that the "Four Seasons" consortium of banks was behind those concerns. We haven't heard from that group for a while now, but perhaps soon. One is tempted to quip that they might be down to only one or two "Seasons", but the banks that make up the consortium stand relatively strong.

Meanwhile, the CME's regulator finds that its prestige has increased relative to the SEC. Why should the CFTC be under periodic Congressional review but not the SEC?

Timely public prices and agent incentives make a crucial difference. I hope that the implementation of TARP and other government programs will not be lacking on these points.


  • Jason - great post. Bang on.

    "It was only a few months ago that the DOJ questioned the legality of exchanges such as CME operating clearing businesses."

    I'd like to know more about this.

    By Anonymous Tom Davis, at 7:25 AM  

  • Thanks Tom

    Here is the background:

    I haven't seen Four Seasons implicated anywhere, but their influence seems pretty likely from here.

    By Blogger Jason Ruspini, at 6:29 PM  

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