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Custom Derivatives are the Darkest Corner of the Wall Street Casino

Posted by Larry Doyle on August 31, 2009 4:16 PM |

Why is it that Wall Street is lobbying VERY heavily to delay and dilute expected reforms for the derivatives market? Well, given that Wall Street is making multiple billions in this space, it is not difficult to understand that the industry will spend millions to protect the franchise. In fact, the industry has been aggressively lobbying to maintain the veil of secrecy on this segment of the market.

The profits generated in this space are centered on 5 banks:  JP Morgan, Goldman Sachs, Citigroup, Morgan Stanley, and BofA. Bloomberg takes a peek into the highly profitable but excessively opaque world of derivatives in writing, Wall Street Stealth Lobby Defends $35 Billion Derivatives Haul:

Wall Street is suiting up for a battle to protect one of its richest fiefdoms, the $592 trillion over-the-counter derivatives market that is facing the biggest overhaul since its creation 30 years ago.

The Washington fight, conducted mostly behind closed doors, has been overshadowed by the noisy debate over health care. That’s fine with investment bankers, who for years quietly wielded their financial and lobbying clout on Capitol Hill to kill efforts to regulate derivatives. This time could be different. The reason: widespread public and Congressional anger over the role derivatives such as credit-default swaps played in the worst financial crisis since the Great Depression.

Wall Street would clearly like to keep the derivatives enterprise running in a ‘business as usual’ format. How might some light shine into this corner of the casino? Require the banks to report trading activity. I detailed this topic in July when writing, “Can We TRACE JP Morgan’s Business?”:

There is little to no transparency in the world of customized derivatives and as a result the bid-ask spreads are very wide. Cha-ching, cha-ching. Jamie and his friends on Wall Street are working extremely hard to keep it this way.

In their defense, it is likely not functionally feasible to move many customized derivatives to an exchange. What should regulators compel them to do? JP Morgan and every other financial firm on Wall Street should have to report every derivatives transaction to a system known as TRACE, which stands for Trade Reporting and Compliance Engine.  This system currently only covers transactions within the cash markets and not derivatives.  What does that mean for investors? No transparency and price discovery for investors in the customized derivatives space. As such, Jamie and friends can keep those bid-ask spreads nice and wide and ring up huge profits in the process.

I won’t make many friends on Wall Street, and perhaps lose some of my current friends, but TRACE should be implemented across all product lines. For those involved in the markets, please access the TRACE system to gain a wealth of pricing data while keeping your brokers and financial planners honest!!

Bloomberg offers a similar sentiment today in writing:

“Part of the pull and tug is that the banks are trying to prevent more and more of the product from being commoditized in the sense of being exchange-traded,” said Charles Peabody, an analyst at Portales Partners LLC in New York, which provides institutional equity research. “Like anything that starts to get commoditized — we’ve seen that with Trace on the bond side — it’s obviously going to pressure margins.”

Trace, shorthand for the Trade Reporting and Compliance Engine, was created in 2002 to post prices on all registered corporate bonds 15 minutes after trades occur. The public disclosure meant bond dealers no longer had better price data than clients, and profit margins in the business shrank by more than 50 percent, according to a Bloomberg News review of trades and a study published by the Rochester, New York-based Journal of Financial Economics.

If derivatives were required to be reported via TRACE and also had to be settled via a clearance system, would AIG have been able to take such massive systemic risk? Doubtful. Yet, Wall Street wants to keep the lights dimmed in this corner of the casino. Will they ever learn?


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