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Did someone say regulation?

June 24, 2011

FogOfWar has kindly offered the background below on the OTC market and an analogy with the bond market, inspired by this recent article describing the latest round of watering-down of derivatives regulations.  The bottomline for me is that whenever you see people using the phrases “needlessly tying up capital that would otherwise be used to create jobs and grow the economy,” “would damage America,” or especially an emphasis on “U.S. firms,” it probably means they are trying to engender a local nationalistic fervor to camouflage a very basic greedy instinct.  Here’s the background:

OTC derivatives, by definition, are not traded on an open exchange, but are entered into between two parties in a private transaction.  We can use JPMorgan and United Airlines as a running example.  United has some risk it has that it wants to hedge.  Or maybe some banker has convinced United that they should be hedging a risk that they didn’t know they had until the banker showed up to tell them about it.

For some simple things, United could just go to an exchange (a stock market, but not limited to stocks).  So, for example, United could buy a future on oil prices to lock in its cost of oil over the next year.  The problem is that there actually aren’t that many different contracts traded on exchanges, and the risks don’t usually fit neatly into the contracts that are there to buy.  There’s a whole chapter on how to get a best-possible hedge in this situation in Derivatives 101 (and probably a whole class after that and people who make a living doing it in real life).  So you could ‘dirty hedge’ (do an imperfect hedge), or you could go to JPMorgan and ask for an exact hedge.

JPMorgan is happy to give you the hedge and either delta hedge out the risk and/or match against offsetting risk they have on their books (or even use the opportunity to take a speculative position they were thinking about anyway).  The key point is that JPMorgan quotes you a price, but it isn’t a price on a transparent market–it’s just whatever price they think you’ll pay.  If United is smart, they’ll farm out the hedging for a bunch of bids from different banks and try to get the best price, but they’ll never actually know if they got ripped off or not, because they don’t see how much it actually costs JPMorgan to cover that risk internally.

There are some areas where the hedges are common enough and enough people offer them OTC that the profit margins are pretty low (simple interest rate swaps are a good example).  However, there is also a lot of money to be made from ripping off dumb customers like United when they wander outside of these areas into other areas where they get crap pricing.  This is how derivatives trading desks make their bonus.

And that’s why JPMorgan cares about this legislation.  They want to keep ripping off the United Airlines of the world, and if the government makes United go to an actual exchange with open prices, there’ll be competition and the profit margin will shrink.  Adding a margin requirement is a bit more wonky, but at the end JPMorgan doesn’t like it because it might drive United to an exchange and away from an OTC derivatives trade with JPMorgan.

It may go without saying, but Jamie Dimon, JPMorgan, GS, BofA, etc. do not give a shit whatsoever about United, Shell, Alcoa, or any other corporate.  They just want the profits from their OTC derivatives trading desk to keep rolling in–profits that come off the backs of their customers–and they’ll say whatever garbage they think Congress and the Agencies will swallow to keep the trades rolling.

Felix Salmon wrote all this up a ways back when Barney Frank was caving to the investment banks and putting the end-user exception into Dodd-Frank to begin with.  That was around the time my opinion of Barney Frank went from “rock star” to “big fat pussy”.  The history (Salmon honed in on this) tells the story in the world of bond trading–what follows is a very general overview from memory:

Once upon a time, if a corporate wanted to buy bonds, they went to their investment bank.  They didn’t see exchange-listed prices, and maybe they got a few quotes to try to get good pricing, but at the end of the day, much like the OTC derivatives market described above, they either had to take a price offered by a bank or not.

Then the government came in and said bonds should be traded on open exchanges (with bid and ask prices available for participants to see).  The banks said it would destroy the market, they said the corporates would suffer, they said the markets would move overseas, they probably said it would “hurt America” to do this.  All of exactly the same horse shit Jamie Dimon and the banks are saying now about moving derivatives to exchanges.

Well, bond trading got moved to exchanges and exactly none of the things the banks warned about actually happened.  Instead, the thing all of the banks were secretly fearing did happen: customers got good execution at lower prices and bank profit margins in the bond business slowly collapsed over time to a fraction of what they were back in the OTC-bond days.  Go figure.

Categories: finance, FogOfWar, news
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