The Fate of Derivatives Regulation

October 18, 2009 1:48 PM

Last week the House Committee on Financial Services approved legislation to regulate derivatives. Some critics contend that the legislation does not go far enough, and there is fear that there are too many exemptions to the rules: reforming the $42 trillion market for credit swaps is crucial if taxpayers are to be protected from future rescues of institutions deemed not only too big but also too interconnected to fail.

Derivatives have been called the crystal meth of our financial sector, and the "financial weapons of mass destruction" that were the single greatest cause of the economic meltdown. Calls for their regulation have been growing since the financial crisis began last year.

Recently, amid the continued outcry and criticism about the handling of the financial crisis, a team of computer scientists has concluded that:

...derivatives may be computationally intractable to price even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields... [.pdf link to their findings.]

posted by HP LaserJet P10006 (25 comments total)

The Obama administration is not likely to do much in the way of instituting much regulations but will as seems the way things are done make some modest changes, proclaim that a lot has been done to correct what needs fixing, and then hope to wafgfle on the next issue.
Frank Rich has it right, as ususal:

http://www.nytimes.com/2009/10/18/opinion/18rich.html?_r=1&ref=opinion
posted by Postroad at 2:40 PM on October 18, 2009 [1 favorite]

Oct. 19, 2009
NEW YORK CITY - Flush with cash from Q3 earnings, Goldman Sachs announced the purchase of a fleet of freight trucks to drive through the House Committee on Financial Services derivatives legislation. Asked to comment, Goldman CEO Lloyd Blankfein said, "HAHAHAHhahahaha! HAHAHAHAHhahahahaah!"

The new SEC enforcement COO, Adam Storch, gave Mr. Blankfien a slap on the back and was quoted saying, "KA-CHING!"
posted by ryoshu at 2:44 PM on October 18, 2009 [4 favorites]

The sentence soon after that quote is the interesting one:

This can be viewed as an extreme case of bounded rationality whereby even the most sophisticated investment banks such as Goldman Sachs cannot be fully rational since they do not have unbounded computational power.

I haven't finished scanning the paper but do they make a stronger case between computability and rationality? Because that seems to be the weak point of the implication.
posted by napkin at 2:45 PM on October 18, 2009

Postroad: "The Obama administration is not likely to do much in the way of instituting much regulations..."

But existing regulations will be enforced by someone with a lot of experience. Someone whose independence we can rely on.

Right?
posted by Joe Beese at 2:46 PM on October 18, 2009

napkin: in economics-speak, "rational" means acting in your own best (measurable, usually fiscal) interest. if the action in your own best interest is unknowable because "best interest" is uncomputable, then computational intractability is ipso facto a boundary condition on rational behavior.

tl;dr: you cant be a rational actor if circumstances make it impossible to know what youre doing
posted by jock@law at 2:49 PM on October 18, 2009 [1 favorite]

The thrust of my question was whether "action in your best interest" is always computable. I suppose in economics it might be, I just saw no effort in the paper to demonstrate that.
posted by napkin at 2:58 PM on October 18, 2009

As long as they don't try to pass a bill saying d(x^2) / dx = x or something dumb.
posted by GuyZero at 3:39 PM on October 18, 2009 [3 favorites]

One of my closest friend's fathers actually created derivatives as we know them now. He's a super-nice guy. But we all (especially his son) still blame him for the global financial meltdown. It's a weird sort of dissonance being able to pin a disaster on a guy who you know to be otherwise harmless and sweet and fun, especially when you're so close to his family.
posted by Navelgazer at 3:52 PM on October 18, 2009

We are no going to get this right anytime soon. The smartest people in the world remain confused over this market.
posted by caddis at 4:10 PM on October 18, 2009

Essentially, there has developed a system where a very small group of the earths inhabitants can bet egregious multiples of other peoples money on the unknown outcomes of a series of algorithms they themselves developed. Just the act of developing, marketing, analyzing, and handling these transactions - all requiring nothing more than a few keystrokes - generates billions in operating profits.

How the bets returned is almost moot. The upside is measured in Trillions, the downside considerably less so, as government institutions absorb the worst. In this way economic booms favor the 1%, and busts favor the 1% as well - the true risk being nothing more than the spread between exponential profit and the pain society is willing to bear for folly.

Stock Markets are Not Democratic
posted by Aetius Romulous at 4:15 PM on October 18, 2009 [1 favorite]

I'm all for this regulation, but I think it's worth pointing out that "derivatives" as a whole are not the financial bogeyman they've been labeled as by people searching for someone to blame for the financial crisis. If used correctly, derivatives provide an important part of risk management in many financial sectors, allowing people to hedge their exposure to undesired risks--for example, farmers buying futures contracts on their crops to hedge against falling prices. The fact that some institutions took heavily leveraged speculative positions using derivatives and ended up bankrupt doesn't imply that the idea of a derivative itself is flawed. And yeah, maybe they're impossible to price correctly, but that's true of a lot of financial contracts (try pricing hurricane insurance sometime). In fact, I don't think it's too crazy to say that the whole insurance industry is a kind of derivatives market--the payoff of an insurance contract "derives" from the occurrence or nonoccurrence of an event--and we all seem to agree that insurance can (at least in theory) be an important, stabilizing part of society.
posted by albrecht at 4:25 PM on October 18, 2009 [3 favorites]

We are no going to get this right anytime soon.

Except that I don't know how much time we have for the kind of sweeping financial reforms we so clearly need: given, that is, the inherent instability of the system, the tremendous risk involved, and the unprecedented scope of the problem.

Summers Says Financial System That Causes Crisis Every Three Years Demands Reforms (in other words, the bailouts were meant to buy us time until the next crisis).
posted by HP LaserJet P10006 at 4:25 PM on October 18, 2009

that some institutions...ended up bankrupt...

Actually, the financial institutions that were facing potential bankruptcy averted it by being given, without any strings attached, access to literally trillions of dollars of taxpayer money. Whether or not this will eventually result in the bankruptcy of the country at large remains to seen.

insurance industry is a kind of derivatives

A lot of people have suggested derivatives be classed as insurance and regulated as such. Keep in mind the biggest problem is arguably not derivatives per se, but the fact that they were totally unregulated (unlike insurance, which is heavily regulated): resulting in things like the AIGFP fiasco.
posted by HP LaserJet P10006 at 4:36 PM on October 18, 2009

Well I think it's great that we got the foxes to stay in that one little corner of the henhouse. And it's encouraging that we're so sure they'll honor that agreement that we don't even need to try to enforce it. HAMBURGER
posted by BitterOldPunk at 4:57 PM on October 18, 2009 [2 favorites]

This could have been a post, in that it both misquotes the study (in a substantively insignificant way, but sloppy nonetheless) and in that it mischaracterizes it as applying more broadly than it does. The subject of the study is a certain class of derivatives on mortgage-backed securities. It does not seem to apply to interest swaps, for example. As albrecht points out above, derivatives can be used responsibly.
posted by jock@law at 5:20 PM on October 18, 2009

$42 Trillion = 42,000,000,000,000 .... That's a lotta regulation. That market is supposedly 3 times the GDP of the US. I find these large numbers to be somewhat inaccurate as generally the full value of the market would only come to bear if every single derivative or security was cashed out. Something that can never happen, purely because that much money doesn't exist. My understanding of the derivative market is that eventually, after something has been traded 100x over, the origin of what it is being derived from is unknown. Something akin to musical chairs on a cosmic scale, where everyone keeps dancing around only to see that, when the music stops, there are no chairs. How people who knew this and yet still believed this system could sustain itself is beyond me.
posted by msbutah at 5:34 PM on October 18, 2009

derivatives can be used responsibly

For what it's worth, I don't think anyone in the post, the links, or the thread, is arguing otherwise. It's just that we have yet to see this market be regulated in such a way (indeed, at all) so as to ensure that is in fact run responsibly. We've seen the opposite unfortunately, where guys like Joseph Cassano can cause absolutely breathtaking collateral damage (through CDS's) to the world's financial systems.

subject of the study is a certain class of derivatives

What seems to be missing here for some folks is understanding of the scale of what we're talking about: Gary Gensler, who is in many ways responsible for the deregulation that led to this market's explosion, says (in the interview I linked to in both the FPP and in my comments above) that the combined notional value for the global derivatives market is 600 trillion dollars.

Any market that large, that remains unregulated and also, according to almost universal consensus, has already caused so many problems, is worth thinking about: thus, even if the paper linked to in my FPP is only applicable as a theoretical framework to a "certain class" of derivatives (which seems debatable, but whatever), it's not especially relevant:

since even something like 1% of the total notional value of the derivative market is already very, very large, and furthermore since the point of the paper in the FPP is not polemical. It was really just added to confirm how analytically inscrutable and wildly complex derivatives, as mathematical devices, can be. The very fact that so few people fully understand a financial instrument that is responsible for such an enormous and globally intertwined market should give anyone (who does not have an axe to grind) pause.
posted by HP LaserJet P10006 at 5:58 PM on October 18, 2009

For what it's worth, I don't think anyone in the post, the links, or the thread, is arguing otherwise [i.e., that derivatives can't be used responsibly]

I don't know, I think when you say things like "Derivatives have been called the crystal meth of our financial sector" you're implying something pretty harsh about their inherent flaws rather than, say, how they're used [or maybe you think crystal meth can be used responsibly?]. It seems like an unnecessarily inflammatory comparison to make, especially since the linked article basically sheds no light on why they're like crystal meth except that Warren Buffett lost a bunch of money betting the wrong way on the S&P. It's not clear how any amount of regulation would have kept that from happening. Does it mean we should outlaw derivatives altogether?

My point is just that we shouldn't confuse the bad behavior of people in charge of financial institutions with the financial instruments they use to make those decisions. When I hear people like Thomas Bass describing derivatives as an evil force lurking in our financial system, I feel like they're missing the point that a whole lot of modern finance [even the good, non-corrupt part] depends on the kind of risk management that derivatives offer. It's like blaming fractions or percentages.

Also, just a side note: I think it's somewhat misleading to refer to the "total notional value" of the derivatives markets as a figure with much significance. Notional value is just a number that's used to determine the terms of a contract. So you might have a swap, for example, that's based on exchanging interest payments on $10 million, but that doesn't mean that the $10 million actually "exists" anywhere or is potentially at risk. It's just a reference value, and comparing the $600 trillion notional value of the derivatives market with the total market capitalization of the stock market or the GDP is apples to oranges.
posted by albrecht at 7:23 PM on October 18, 2009

when you say things like "Derivatives have been called the crystal meth of our financial sector" you're implying

I'm not implying anything; I said they have been called. I have eleven links in my FPP; apparently one of them upset your semantic sensibilities by applying what seems to you like a faulty analogy. In other words, you are nitpicking and being pedantic.

It's like blaming fractions or percentages.

And we would need to regulate those too if they could be used to recklessly gamble and endanger the world economy the way derivatives can be.
posted by HP LaserJet P10006 at 8:25 PM on October 18, 2009 [1 favorite]

All standardized derivative trades between dealers and large market participants also would go through central clearinghouses that would act as middlemen, and the trades would have to take place on exchanges or electronic trading platforms, adding transparency to what has been a murky and mysterious market.

Good, this is long overdue. I'm not sure exactly which derivatives are going to be standardised though. Hopefully CDSs will be, but I'm not sure that even if they were traded through a clearinghouse there would sufficient liquidity to make a meaningful difference.

Also note that straight Mortgage Backed Securities are not covered by this (although the synthetic ones are).
posted by atrazine at 12:29 AM on October 19, 2009

when you say things like "Derivatives have been called the crystal meth of our financial sector" you're implying

I'm not implying anything; I said they have been called.

Some would call that a weasel word.

I have eleven links in my FPP; apparently one of them upset your semantic sensibilities by applying what seems to you like a faulty analogy. In other words, you are nitpicking and being pedantic.

I think this is a good post with a lot of new information, and I especially like the computational complexity argument; that's something I hadn't seen before. I also happen to be strongly in favor of this new regulatory framework, because I think too much of the derivatives market exists in the shadows where it can't be properly audited. But with the exception of the NYT op-ed (and I hate that I'm on the same side as Chris Cox here, btw), all the articles you link to try to paint the whole derivatives market with the same brush, which I think is an unfair oversimplification and ignores the facts that (1) derivatives (most of which are already exchange traded and subject to regulation) are an important, perhaps even necessary part of capital markets, and (2) it wasn't "derivatives" per se that caused the financial crisis, but a specific class of very complicated derivatives being used irresponsibly by people who had no business exposing themselves to so much risk. If AIG had bet all its money in a Vegas casino, we wouldn't be talking about whether gambling should be illegal; we'd be calling them out for being stupid and demanding more oversight in their future activities.

The reason people outside the financial world get all upset about ZOMGDERIVATIVES is just that they don't properly understand them or how they work; up until a year ago most people hadn't ever heard of them. Ever gotten stock options from your job? Ever put money in a CD or a variable annuity? Guess what, you've participated in the derivatives market.

It's like blaming fractions or percentages.

And we would need to regulate those too if they could be used to recklessly gamble and endanger the world economy the way derivatives can be.

But don't you realize that EVERY SINGLE mortgage-backed security and credit default swap makes use of percentages? We need to protect the global economy from the threat of these mysterious non-integers!
posted by albrecht at 10:13 AM on October 19, 2009

Really, intractable is a silly thing to care about for the time being. It describes how much computer power you need to solve the problem, under certain assumptions, like being able to accurately convert information into a price, and that sellers actually have asymmetric information. And they readily admit as much:

Most analysis of the current financial crisis blames the use of “faulty models” in pricing derivatives, and this analysis is probably correct. Coval et al. [CJS09] give a readable account of this “modelling error”, and point out that buyer practices (and in particular the algorithms used by rating agencies [WA05]) do not involve bounding the lemon cost or doing any kind of sensitivity analysis of the derivative other than running Monte-Carlo simulations on a few industry-standard distributions such as the Gaussian copula.

posted by pwnguin at 1:02 PM on October 19, 2009

Ugh. I think this is really the wrong approach. The problem isn't the derivatives, the problem is financial institutions (or any institutions, for that matter, but particularly ones engaged in taking risks in order to turn a profit) becoming so big that they'll take down huge sections of the economy if they fail. That should never be allowed to happen—not the failure, but the growth to that size in the first place.

It doesn't surprise me that we're looking the other way, though, and regulating derivatives instead, because those companies still have a near-lock on the government and regulatory apparatus. They'd rather see derivatives demonized and regulated than be broken up, so that's what we're going to get.
posted by Kadin2048 at 2:47 PM on October 19, 2009

with the exception of the [Chris Cox] NYT op-ed...all the articles you link to try to paint the whole derivatives market with the same brush

I don't think this is true at all; to give but one example (from the fourth link, the NYT piece by Gretchen Morgensen, and the sentence directly preceding the one I quote in the FPP): In the right hands, they help parties manage risk. In the wrong hands, they are among the most destructive financial products ever invented...

Despite your anxieties that derivatives are being scapegoated, very few people who are writing about this issue are advocating banning derivatives outright (although there's probably a case for that as well); most reform advocates just want them regulated the same way things like commodities futures or insurance policies are.
posted by HP LaserJet P10006 at 7:13 PM on October 19, 2009

Also, let's be honest about the tendency for unregulated markets to attract sharks:

Arrest of Hedge Fund Chief Unsettles the Industry (10/18/09)
posted by HP LaserJet P10006 at 7:39 PM on October 19, 2009