Derivatives Reform, 5/20: The Two Loopholes That the Fight is Over

[laughingliberal]

Over the weekend, Shahien Nasiripour had a writeup of this second derivatives loophole issue. Inside the second derivatives loophole issue is two issues, one being the penalties for not trading on a clearinghouse and the second being what if a clearinghouse turns down a derivative:

Furthermore, the email points out, even though federal regulators may require that a swap be cleared, they can’t mandate a clearinghouse to accept it.

Parties wanting to enter into a typical derivatives contract usually go through a middleman called a Futures Commission Merchant (FCM). The entities will then take the contract and submit it to a clearinghouse. These merchants have the authority to reject contracts.

The biggest futures commission merchants are owned by the largest banks, according to data collected by the CFTC. The largest banks also act as the dealers of derivatives. The big banks dominate the market. They also stand to lose the most revenue because of the increased transparency.

Let’s say you wanted to keep a derivative that has been flagged for clearing in the “dark”, off the grid of clearing and swap execution facilities. One way is to simply not put it through the clearinghouse. There are penalties for doing this if the CFTC wants to enforce it. Why not make those explicit, and allow market players more clear right in the law? You’d be sure it would get enforced if these rights were broadly distributed rather than through the coin toss of who is running the government that year. <snip>

Full explanation at link: http://rortybomb.wordpress.com/2010/05/20/derivatives/

[T Wolf]

1. Actions which continue to legitimize the manipulation and non-investment gambling

that is the basic characteristic of our financial system will do little, if anything, to solve the problem.

The entire system needs to be scrapped and simplified - so that investment is truly that.

Gambling on failure should not be legal, especially when they cause so much damage in manipulating things to insure the downfall of the asset they are betting against.

[Statistical]

2. I think your definition is overly broad.

A life insurance policy is gambling on failure. You are "gambling" that you will die soon and the insurance company is the coutnerparty. The shorter you live the higher the ROI on the contract. The longer you live the higher ROI for insurance company.

Likewise a farmer may see that wheat is selling at 486. He knows that he MUST get at least 480 this season for avoid default. He could wait until harvest and hope price remains high or he could sell a futures contract against his harvest now.

He sells a futures contract for 490 for November delivery. Now if the price of Wheat is below 490 he is protected and will still get paid 490 (no default on his farm loan). On the other hand he is trading away any potential higher prices. If supply is low and demand high prices shoot up to 530 he has "capped" his revenue for this year.

[T Wolf]

3. An individual farmer usually does not have the ability to destroy the economic viability

of an entire nation in order to make their hedge bet pay off.

The life insurance company (usually) will not work to cause your life to be extended (not a logical parallel, but the meaning is obvious) so that you keep paying premiums.

It is the scale of the gambling without having to actually put up any money that is causing the problem. What about putting a "table stakes" rule in whereby the "investors" (yeah, right) have to have the cash to cover their losses before they are able to place the bet.

The zero-sum game that the banksters and Wall Street criminals have concocted produces distortion so that they are not really investing, but gambling against the success of something. That is simply immoral and should not be allowed, especially on the scale that these assholes operate.

[Statistical]

4. A farmer buying a futures contract as a hedge or insurance company selling you life insurance are

both examples of zero sum contracts.

I agree derivatives need to be regulated, counter party risk removed (via exchanges), and more transparency brought to the market.
Large banks need to be limited on maximum exposure and leverage to avoid a systemic risk. All parties need to be moved out of the shadows and on to markets where price discovery and transparency are available.

Still your call for eliminating all "gambling" is simply overly broad definition. There are legitimate uses for derivatives as a hedge against the unexpected.

A farmer can't offload risk without someone willing to assume that risk. The person willing to assume it is a speculator.

It is simply impossible to eliminate risk you can only shift it.

When I sell a covered call option contract I am not eliminating risk I am shifting it to the speculator who wants to buy it. Usually it works out against him but occasionally the stop makes a large move and the buyer profits.

You can't have hedges without speculators. They are opposites sides of the same coin.

[T Wolf]

5. The very definition of speculator is one who does not actually contribute anything as compared

to an investor.

Hedges are simply more gaming the system.

Risk is part of life, unless you are rich enough to eliminate it. They have. In their drive to avoid consequences (sound familiar?), they have created a system where the risk is socialized to those of us not in the executive suite while they rake off all the profits into their private, offshore accounts. I cannot see how anyone with any ounce of decency can defend that system.

My position is that the more complicated the system, the easier it is to manipulate. And the financial system we all suffer under is far too complicated to understand (or regulate, even if that was the goal of those in power).

It needs to be torn down and rebuilt under extremely strict rules. Limit investing to backing an endeavor that is supposed to succeed.

I have a cousin who is neck-deep in the many of these schemes. He uses the same language you do to justify the manipulation for "winning the bets" he places.

The fact that events and conditions that are no way connected to the original "investment" can determine its outcome is just plain wrong. Example - here in the Philly area, a mall almost was forced to close, not because the stores there were unsuccessful, but because someone way up on the food chain had lost money on some other scheme and needed cash to cover another bet to recoup his losses. So, he almost forced the mall to close by calling in some questionable "paper". There is something basically wrong and immoral about that.

But the financial gods would say that there is nothing wrong with that scenario.

I do not realistically see much improvement being made to the system as long a those writing the rules profit so obscenely by it. Until people get fed up enough that the bodies of these cretins start winding up in the street, we will continue to be played for suckers.

[Statistical]

6. You don't get it.

Say a farmer want's to hedge the price of Wheat. He is willing to accept a little less than maximum price in return for a hedge that prices won't be below x. That is a hedge.

Same thing when an airline uses oil futures to hedge the cost of diesel. Remember when you buy a ticket today the airline has to guess what it will cost to fuel the plane in 30, 60, 90 days from now.

The same thing applies when a pension fund is willing to accept a lower return for protection if/when bond defaults.

In all these instances the person is willing to accept LOWER return in exchange for PROTECTION.
Limiting profits but also limiting losses. In essence the farmer, the airline, and the pension fund are selling RISK.

The person buying it is accpeting higher profits in exchange for potential of higher losses. You can't make risk go away. You can simply transfer it. Derivitives are simply a mechanism to transfer risk. If the farmer wants to be guaranteed 480 for wheat someone else (counterparty) must will be willing to accept the risk that prices will be higher or lower.

If wheat is higher than 480 then the farmer was wrong (he would have made more revenue without the hedge) and the counterparty profits. If wheet is beloew 480 then the farmer is right (hedge saves him from declining revenue) and the counterparty loses.

Risk doesn't mean a loss it simply means uncertainty. Someone else will either profit or lose on that contract.


You can't hedge without someone else taking the risk. One person being conservative, one person being speculative. They are 2 sides of the same coin.

[T Wolf]

7. You want to gamble on a poker hand - fine. Just don't do it with my (tax) money and

manipulate conditions to ensure that your bet wins.

If that individual farmer wants to take out insurance, do it in a straight-forward manner. Only the farmer and the insurance company should be involved. Neither should be able to foist off their bet on another, unconnected entity. It is the second-through-hundredth-removed entity that is only in it for the gamble that fucks things up.

It is as if the hedge0fund cretin takes the bet from the farmer, packages his bet into a larger deal with a large corp somewhere else that hires a crop duster to poison the farmers fields, forcing a loss of produce. Price rises for rarer output so farmer loses out and hedge funder steals the excess. Fair, huh?

There must be limits to how far away from the original issue these manipulations can be.