Yesterday, the news hit that the Department of Justice is investigating Markit, the major provider of derivatives data, pricing information and indices. That news failed to explain why the DOJ was so interested in Markit, though speculation pointed at antitrust. Today, the Wall Street Journal reports that hunch was right. In trying to understand how large banks, through Markit, might be manipulating derivatives pricing, I realized something: I don't understand how the derivatives market works. And neither did anybody else I asked.
I mean, I understand basic market process and the derivatives themselves. But if you asked me procedurally what traders did, how the big banks might have an unfair advantage under the current system or what should be done to fix it (if anything), I couldn't answer. I worked at a bank originating bonds, but like most others in financial services, I was never actually exposed to what traders do. I just called them from time to time to ask them about the market.
The people I asked also had trouble explaining derivatives. And I'm not talking about the guy who makes my sandwich at the deli downstairs. I consulted a derivatives lawyer to see if he could explain the pricing mechanisms. He couldn't. I called up a major banking lobbyist to see if he could explain. He couldn't either. I asked him to see if he could dig someone up to talk to me about how the market works. He said he would call me back once found someone. He never did.
Why does nobody understand the derivatives market? Probably because, up to now, nobody really cared how the derivatives market worked. It just did. Then, credit default swaps shook the earth. Suddenly, regulators care, politicians care and investors (who lost lots money on seemingly safe bets) care.
I'd love to find someone who could really explain the ins and outs of the derivatives market. What do derivatives traders do day-to-day? How do derivatives traders at banks like Goldman manage to make billions? What unfair advantages might big banks have in the market that could be angering the Justice Department? What regulation should be imposed to make the market better?
If you're up to the challenge, comment away and let us know. If you think you can write a lucid explanation, we might even ask you to do so for our website.
At your service...
Dan:
Suggest that you contact the folks at www.moneymorning.com and find a way to speak with Shah Gilani. The man knows his stuff and has written a number of items on the CDS market.
In the unlikely event that Charles can't answer your questions, try contacting the blogger behind Economics of Contempt or the anonymous trader at www.acredittrader.com.
Do you mean just CDS or all types of derivatives? Futures and options traders conduct business similarly to equity traders, just in different markets.
I'm more informed on energy derivatives, never having dealt with CDS or equity based derivatives, but the gist of it is they are traders sitting at the trade desk working the markets. They make calls, they IM each other for deals, and place trades. Just like equity guys (and gals) they watch the charts, sometimes trade using quantitative computer based strategies, and try not to lose their butt like everyone else.
The advantages of a big bank are the same in derivatives as they are in the equity market. Large market makers have the ability to move pricing when they buy and sell large percentages of any market. As far as making billions at GS, well, its leverage. Lots and lots of leverage. That's why I like derivatives more than equities for my personal portfolio. I'm not Warren Buffet so I can't take huge outright positions, but I can leverage up with options.
However, those crazy fat cats on Wall Street may work differently than us humble energy traders in Houston, though I doubt it. Look at BP, they trade almost twice as much gas and derivatives than Enron ever did and hardly anyone knows it. In the end it is not really mysterious, but due to the closeness of the traders it is often rather incestuous.
A financial derivative is an instrument whose value is dependent upon the performance of another variable such as a financial security (i.e. a stock future or option), a company's ability to repay its debt (i.e. a credit derivative), an interest rate (i.e. a swap), another derivative (i.e. a CDO^2) or otherwise.
A derivative trader on a day-to-day basis is responsible for providing a liquid market (consitently offering to buy or sell) for a particular derivative. They make money just as any other market maker does: the spread between how much they will buy it for and how much they will sell it for. The goal is to line up buyers and sellers on either side, and then buy from one and sell to the other.
One difference between a derivative and an actual security market maker, is that each counterparty will face the derivatives dealer in each side of the transaction. So, in addition to the inherent risk of the transaction, there is also a risk that the derivatives dealer could go bust thereby converting the holder into a creditor of that dealer. This is probably where the "unfair" (but not genuinely unfair) advantage comes from.
Let's say you want to be a derivative trader. Nobody is going to trade with you, because if they buy something and the price of it goes up, and if you're not worth as much as the value of the derivative, then you can simply declare bankruptcy and they're out of luck in getting that money from you. In the example of Lehman Brothers, they built up a very complex web (as any derivative dealer would normally do) of trades, and the systematic unwinding of trades (netting out people who are owed money and people who owe money) can get equally complex. The reason why people trade with dealers such as Goldman is because they know that they are capable of paying any amount owed on their derivative bets.
But, this assumes that they do have a risk neutral portfolio whereby they have an equal number of buyers and sellers on each side of the fence. If a dealer were to stack up a bunch of these contracts so that if it the bet goes one way they make a boatload of money, and if it goes the other way they declare bankruptcy, then that's obviously what could become a "shock" to the financial system. This is what market regulation is meant to deliver. Transparency will lead to investors and counterparties knowing that someone is ensuring that a dealer isn't taking too significant a position in a derivative. But, if this information is too transparent, then other dealers can change how they price securities in order to squeeze out certain dealers.
I'd be more than happy to delve into further detail on this, so please feel free to contact me.
The CDS market works similarly to any other market: traders announce prices (privately or otherwise)at which they are willing to trade, and if two traders' levels agree, a trade may be executed. These levels may be informed by quantitative models, gut feelings, even sheer necessity - but the mechanism by which trades are conducted is quite straightforward: two CDS traders agree to a trade, at which time their respective firms enter a legally binding contract to exchange the necessary cashflows. That part takes place off the desk, however.
There are two predominant forces in the CDS markets - again, as with most markets - the "buy side" and the "sell side". The buy side refers to those traders looking to place directional bets; they look to trade securities as advantageous prices, hold them for some time, and then sell them at a profit. The sell side, by contrast, is not interested in taking risk; it merely wants to service the buy side and be compensated for doing so. To accomplish this, sell side traders seek to simultaneously buy and sell the same security, capturing the difference in price for themselves and taking no exposure to the security in the process. The market dynamics arise out of this tension - buy side traders looking for "good" prices, and sell side traders seeking to capture a "bid ask" spread. Increasingly, however, sell side traders are starting to resemble the buy side as banks take on proprietary risk (evidenced most recently by Goldman Sachs).
It would appear that most of the regulatory concern with the CDS market is not about *how* contracts are traded, but rather the management of those contracts themselves. The CDS market is an "over the counter" (OTC) market, meaning transactions are executed between two consenting parties rather than via an anonymous exchange. In any OTC market, there is an advantage in being "the counter" - or the sell side. This is because the sell side 1) has an information asymmetry in that they see much more of the market than any individual buy side trader and 2) can adjust their price - even away from the "fundamentally correct" price - to take advantage of the supply or demand they perceive in the wider market. Thus, one of the first regulatory aims is increased price transparency.
A second concern is how each trader's firm treats the contract after it has been traded. AIG was not required to post collateral on their sold CDS, and consequently was ruined when they discovered they had sold more contracts than they had collateral to back them. Lehman's bankruptcy locked away funds owed to other firms, because they did not only have exposure to the firm they traded CDS *on*; they had exposure to the firm they traded *with* as well. The regulatory solution to the issue of counterparty risk is to create a CDS clearinghouse, which will standardize all collateral disputes and decrease counterparty risk throughout the market.
Finally, people are afraid that CDS are mathematically complex, difficult to price products - and to an extent they can be. Nonetheless, this fear arises with many derivatives, because they do not trade on an open market and do not represent "pure" parts of the capital structure (as if companies only issued simple stock and bonds in the first place). A response would be that having a mathematical grounding should actually increase people's faith in receiving an honest price, for in the absence of a highly liquid market, how else can you determine whether a price is fair? Thinly traded stocks may jump tens of percents each day, because there is no price discovery mechanism - and without a grounding in transparent math, who can say what the proper level is? Unfortunately, many attempts to explain CDS veer into complex math simply because they can, not because they need to. CDOs, while more complex, have a similar problem (though I have recently tried my hand here: http://www.thisisthegreenroom.com/2009/deconstructing-the-gaussian-copula-part-ii/).
I believe that these three items: OTC, counterparties, and scary math have greatly contributed to the demonization of CDS contracts. As Petrobull stated, the incestuous nature of many trading desks and sometimes-difficult trading vocabulary only add to the confusion. Moreover, we have seen the concrete and disastrous toll that derivatives can have in AIG and Lehman, among others, cementing (or necessitating the invention of) the error of these market's ways in our collective psychology.
If it would be helpful to expand on any of these, please let me know.
I would recommend Satyajit Das -- or maybe just ask somebody over at Wilmott whom they would recommend. David Harper over at Bionic Turtle is someone else who could probably help.
J's writeup is very good. Especially the asymmetry part of the buy/sell desks. If anyone is lost, Hayek is a good guide here - prices have information in them, so information on prices (which is, control over information) is very valuable; the ability to lean on prices, control the flow of information of prices, or have an oligarchy over the market for information on prices, is distorting the whole reason we have markets.
We want price information accessible broadly and clearly presented so people can make their marginal decisions off of it. If it is just a matter of having a math model, we could grab a high-energy physics PhD and make him the social planner, programming away the price of tin. That is usually trouble, so instead we want the feedback in prices. I think that's the drama over Markit; they are throwing their weight around hard when it comes to the CDS price information market.
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