Intellectual flexibility – or plain greed

Sometimes it is hard NOT to smile when confronted with the ability of players in the financial markets to adjust their thinking to the circumstances. Does anybody remember July 2008 when Crude Oil was trading about 140$/barrel. We all had to endure explanations that this phenomenon was based on sound facts (oil reserves were to be depleted next Wednesday) and that speculative moves in the very small market for sweet light crude had nothing to do with it.

Yet on July 14 2009 (Crude oil trading below 50$/barrel) the US Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler presented data to a congressional panel that 71% of the oil futures traded on the NYMEX in 2007 had been speculative. And this number even omitted the trades over the London-based ICE – the so-called London Loophole. One of the peculiarities of the legislation in place was that CFTC allowed exactly oil futures to be regulated by the exchanges themselves instead of following standard trade rules. Another peculiarity was that the mandatory reporting of the oil futures was sufficiently light that it was impossible to establish a normal overview of the total market positioning. The Congress granted the CFTC powers to regulate the oil market - accompanied by a howl of protests from the market players.

But that was then. Now the US congress is struggling with something far bigger, the regulation of Over-The-Counter (OTC) derivatives. Some months have passed since the CFTC hearings, the economy is recovering and the financial market players are trying to display some kind of normalcy. Bonuses at silly levels are but one example of this return to normal.

Obama's administration have committed themselves to introducing legislation to regulate the OTC market. OTC is short for a class of derivatives where essentially no contracts are standardised, every transaction takes place on a bilateral basis, and where transparency is non-existing. One famous type of derivative is the Credit Default Swap, the CDS. A CDS is a contract between two parties that one will pay the other an amount if a third party defaults on repaying its corporate bonds. The nominal value of these bets is often many times bigger than the corporate bond issue itself.

Remember AIG? The main reason for the fall of AIG was exactly that the company had been the issuing counterparty of CDS's to the tune of astronomical nominal amounts. A large part of the government money poured into AIG went towards honouring the company's liabilities related to unregulated OTC products. Tax payer money went into paying off gambling debt.

Now the US Congress is discussing to introduce legislation aiming at standardising the products, making sure they are traded in something akin to a regulated market, and introducing a clearing house, so settlement can happen in a transparent way. The purpose is to make it possible to create an overview of the total number of OTC products – in the honourable intention of exposing the risks taken by the banks active in the market for OTC products.

Guess what. Industry representatives are now lobbying hard to avoid just that. We are now told that OTC products are necessary for the consumers, because manufacturers need the products to hedge their raw material costs. We are told that standardisation is an evil because the markets will then not be able to offer customers precise hedging. In other words, the kind of products that one year ago were clear to have played a pivotal role in disguising the risks taken by banks are now again necessary to reduce market risks??

Using Rule #1 of the Private Snoop: Follow the Money, one arrives at a rather more sobering picture. The largest operators in the OTC market have made tons of money in non-transparent OTC product, simply because the bid offer spread on such contracts is astronomical. Forcing the market into standardised products and an organised market would cause bid-offer spreads to narrow sharply, undermining the earnings of the biggest players. So their sudden concern for the consumers' needs is probably just a way of not really telling that derivatives should continue contributing to their earnings.

One can only pray that the US Congress in this instance is not swayed by highly paid lobbyists. What the world needs now is NOT that the financial markets continue dealing with derivatives in the usual hush-hush way. Derivatives are indeed useful, but there has to be some possibility of overseeing the total exposure, and so on. The financial markets have always thrived on the ability of clients and politicians to have very short memories. This time is no exception to that rule.

Maybe there is some hope. John Maynard Keynes – a UK economist, whose teachings were behind the reorganisation of the world economic system after WWII – was quietly dropped from university reading lists across the world. His books have seen a remarkable pick-up in sales over the past months. It is reassuring that there are people who still believe that the government has an important role to play in regulating the economy and the markets. It is particularly reassuring now that the financial markets are back fighting regulation after a combination of unregulated products very nearly blew us all out of the water.