Monday, 25 May 2009

The flight to simplicity

Rick Bookstaber has an interesting if flawed post on the neue sachlickeit in derivatives:
Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.
That would all be true if the list of standardised products stays short. But I am willing to bet quite a bit of money that more and more products will be exchange traded and cleared rather quickly. The sales people - who get paid more for exotic structures - will push hard for this. Soon range accruals and power inverse floaters will go through exactly the same infrastructure as plain vanilla swaps.

Where Bookstaber goes really wrong, though, is a mythologising of the early days of derivatives:
If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line... [things went bad].
Oh grow up. I mean, really. Derivatives were always about tax arb and regulatory arb and ratings agency arb and accounting arb/earnings smoothing. There never was a golden age when derivatives were used just to meet risk management needs, and where unicorns lay down with virgins after the market closed. Swaps grew because they allowed the derivatives desk to lend without the credit department finding out. Credit derivatives grew thanks to a massive regulatory arbitrage. It has always been a client facilitiation business, and what the client wanted, the client generally got (albeit at a price).

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