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The problem is not derivatives, it's the over-the-counter market in custom-designed financial products.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 04:46:12 PM EST
[ Parent ]
Could you elaborate on that?

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman
by dvx (dvx.clt št gmail dotcom) on Mon Jun 18th, 2007 at 05:05:44 PM EST
[ Parent ]
There are two kind of financial products: exchange-traded and over-the counter.

Exchange-traded products are standarised and to some extent trackable (at least in terms of volume outstanding and traded, etc) because of regulatory requirements and those of the exchange itself. Banks provide bespoke financial products to their customers "over the counter", with very limited regulatory oversight or reporting requirements. Financial derivatives and "swaps" can be (and are) used to circumvent regulatory limits, hide transactions and holdings, reduce one's tax base, etc.

I'm suggesting that, if there were no OTC market it would be less difficult (in principle) to have an idea of where the risk is.

On the other hand, it's in the OTC market where "financial innovation" takes place.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:14:04 PM EST
[ Parent ]
You don't need complex derivatives to blow yourself up.

Some hedge funds are taking huge positions on listed derivative markets. It's just that when they fail through listed markets the boom is spread a bit to the clearing exchange members and it happens earlier through margin calls.

Whereas in the OTC market you have only one counterparty that takes the boom (or a chain of counterparties).

AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Banks are supposed to monitor their risk and regulators supposed to monitor banks risk monitoring. If a bank blows up, the boom goes to in order:

  1. shareholders
  2. bondholders
  3. deposits of clients in the bank

Part 3 is you and me money. Did you get a dividend for the risk you're taking? :)
by Laurent GUERBY on Mon Jun 18th, 2007 at 05:35:55 PM EST
[ Parent ]
AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Do you mean no less regulatory requirement?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:39:00 PM EST
[ Parent ]
I mean it's the same reporting requirement.

OTC requirement = listed requirement.

by Laurent GUERBY on Mon Jun 18th, 2007 at 05:44:08 PM EST
[ Parent ]
I don't agree: some mortage CDO's, corporate index CDS, tranches thereof, and all sort of other MBS are all listed stuff with delirial risks. And they will be among the first hit by the subprime meltdown. And the amounts at stakes are openly known, and they are already frightening.

I dont' mean the OTC are not another (possibly bigger) time bomb, I mean it is possible to blow up the planet by taking risk on listed stuff alone, and it has already been done, that listed bomb is cocked ready to set off.

I've seen some CDS on baskets of corporate lenders in europe which, according to some basic industry-standad default event models (thoroughly untested outside of the highly benevolent period of low refinancing rates), have their price go from zero to full pay for changes of just 1 bp at a certain threshold value of the borrower's spread. These threshold values are just a percentage point away from the present rates.

If the corresponding (listed) CDO really fares like the model suggest (symmetric of its default swap), this is going to be ugly, and it will happen, not overnight, but in just weeks as bankruptcies pile up.

Pierre

by Pierre on Tue Jun 19th, 2007 at 10:26:44 AM EST
[ Parent ]

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