Derivatives and the Blizzard of Paperwork

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Frank Partnoy, who has been warning about the dangers of derivatives for years, makes some good points in an op-ed in The New York Times about the Obama administration’s plan for re-regulating these esoteric financial instruments. The former derivatives trader-turned-law professor rightly points out that the Obama plan doesn’t go far enough, and might even encourage Wall Street firms to cook-up more abstract derivatives in the future.

How’s that? Well, the administration’s plan only proposes to regulate so-called standardized derivatives—financial instruments that are similiar enough that they can be traded and regulated on a public exchange. The trouble is a large percentage of derivatives are non-standard instruments, which are custom designed by the parties in privately negotiated deals.

For these, one-of-kind derivatives, the administration simply proposes that a record of these transactions be reported to a government agency. But little information about these complex deals will be disclosed to the public. There still will be little transparency for the bulk of the $600 trillion derivatives market.

Simply requiring parties to report these deals isn’t enough to eliminate the potential systemic risk posed the collapse of a major dervivatives counterparty. Says Partnoy: “All derivatives, exchange-traded or private, must be in the sunlight. If institutions want to negotiate individual derivatives contracts, they should tell investors the full details of their exposure.”

Of course, there’s good reason for Wall Street banks, hedge funds and coporate buyers of non-standard derivatives to continue to keep these deals in the shadows. If the public ever saw just how complex and mind-numbing most derivatives are, there very well might be a cry from the public to ban them, or impose even greater regulation.

Andrew Haldane, an executive director for the Bank of England, gave a good illustration of the complexity of some derivatives in a recent speech in Amsterdamn. Haldane pointed out that an investor in a CDO-squared “would need to read in excess of 1 billion pages to understand fully the ingredients” that went into one of these cockamany securities.

I can guarantee that most institutional investors who snapped-up CDOs during the credit boom never bothered to read even 1% of those 1 billion pages of documents. I can also guarantee that most of these investors never realized they needed to read all those documents to fully understand what they were buying.

Maybe if investors understood just how complex a CDO really was, the market for these much maligned securities never would have taken off in the past decade.

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