Fun with Derivatives

Fresh off my vacation, I have jury duty tomorrow, but today I got a jump on my fun reading for the courthouse – Traders, Guns, & Money, the anecdote-packed overview of derivatives by Satyajit Das, a prolific consultant, author, and commentator on the topic. Das says that his book “does not attempt to make a case for and against derivatives” (p. xiii), and it’s true that he does point out some of the useful, value-creating functions of derivatives. But this passage (p. 41) is probably more typical, and one I thought deserved being typed out:

We needed ‘innovation’, we were told. We created increasingly odd products. These obscure structures allowed us to earn higher margins than the cutthroat vanilla business. The structured business also provided flow for our trading desks. The more complex products were stripped down into simpler components that traders hedged. …

New structures that clients actually wanted were not that easy to create. Even if somebody came up with something, everybody learned about it almost instantaneously. They reverse-engineered the structure and then launched identical products.

In Das’s account, derivatives can be used to unbundle risk – but market competition makes unbundled risks look an awful lot like commodities. So the answer instead is bundle those risks back together into complex products that (a) customers can’t understand and (b) can earn high margins, at least temporarily. Das concludes his tutorial on inverse floaters this way (p. 50): “Greenspan had been right – risk had truly been unbundled. We had just packaged it right back up and shoved it down the eager throats of the wealthy taxpayers of Orange County.”

Which brings me back to something Mike Konczal (last week’s guest blogger – as my daughter would say, “Round of applause!”) discussed a while back – why do so many “innovative” financial products included embedded options? In Mike’s words, “When I was discussing this prepayment penalty theory with a very smart person from a hedge fund, he told me that selling people embedded options is always deviously clever because people don’t understand that they are buying them, and often don’t understand their value.” That sounds to me like the same thing Das is saying.

By James Kwak

18 responses to “Fun with Derivatives

  1. …shoved it down the eager throats of the wealthy taxpayers of Orange County.

    In that case, they cannot be wholly bad.

  2. Yup. Here there’s no such thing as “capitalism” going on – no value being created or added, no innovation, no entrepreneurship (using those terms in their non-Orwellian definitions).

    It’s only the intentional generation of complexity to set up artificial revenue nets which are just kinds of snares.

    It’s nothing but rent-seeking and common gutter fraud.

    Even if Das can flush a few examples of “value” out of the bushes, that would still be literally derivative value given the premise of the financialized rentier economy.

    But financialization itself adds no value, only cost, complexity, aggravation of wealth concentration, and socialized risk. The FIRE sector itself should not exist as anything beyond a miniscule fraction of the economy.

  3. I had a dreadful experience with HSBC. They pushed me for years to come in for a Premier Account pitch on investments. I finally took my lunch hour and saw an advisor. Bear in mind that I was a derivatives trader for a bank at the time, something this guy new perfectly well.

    He spent thirty minutes pitching me currency, stock, and commodity products with embedded options (basket stocks with high/low toss-outs, fixed funds with currency repayment at bank’s option, etc.). I told him over and over again that I would not buy or sell an option. He insisted that these products had no options; “Where,” he asked,”did I see ‘put’ or ‘call’ in the prospectus?”

    The fixed rate investment worked as follows: 8% on either USD or Euros; at the term of the note, the bank will pay back either Euros or USD. He insisted this product was not an option since I had a client profile which used both currencies.

    After I spoke to his manager and threatened to complain to the financial services authority, they agreed to leave me alone. However, how many other non-financial clients bought all these embedded options without understanding a thing?

    As we all know, OTC options on illiquid underlyings have massive margins built in. This was the case in my business where we bought and sold to moderately savy clients. I shudder to think of the kind of margins these banks are taking on their occult and exotic stuff.

  4. can it be that claiming to able to juggle ever higher complexity has become the new it-status-thing for the strut around cocks and hens?
    - the real Maseratis and helipads of this age?

    I object more and more to complexity it is such an abstract word and evil-doers hide comfortably behind abstract words and as a lot of what I read reminds me of this image I try
    complexity like in a ball of yarn after the cat or worse has been at it – my grandmother’s advice for making it in a ball again was “don’t stick it through (openings)” i.e. never succumb to the temptation of this seemingly convenient short cut offering itself

  5. There is real complexity even without introducing artifically-created complexity as a smoke-screen for theft and deception.

  6. We can put our little minds at ease. The Santa Fe Institute has been studying complexity, and according to them, “…its original mission to develop and disseminate a general theory of complexity has been realized.” (As they landed on the deck of the USS Lincoln, you could see a giant banner on the control tower that read “Mission Accomplished”)

  7. Complexity is about how a huge number of extremely complicated and dynamic set of relationships can generate some simple behavioural patterns.

    from http://en.wikipedia.org/wiki/Complexity_science#Complexity_and_chaos_theory

    …or how some extremely simple behavioral patterns can generate some unnecessary complexity to serve its ends.

  8. Financial innovation indeed serves a purppose; few people would argue with that but when financial innovation becomes a substitute for productivity and service growth (whether its because of packaging securities or unbundling CDS) we have a problem. Let’s learn from our mistakes.

  9. Satyajit Das is the most knowledgeable and objective expert in the derivatives market that I know of.

    It’s obvious speculation has become a dominant function of credit default swaps, evident in the fact that volumes in the CDS market were approximately four times outstanding underlying bonds and loans.

    The market is concentrated to a small group of investment banks, which compounds risk. The OCC in the U.S. reported that largest five banks hold 96% of total notional volume of derivatives and the largest 25 banks hold nearly 100%. Government-led consolidation in the financial sector during the crisis exacerbates dangerous concentration.

    Relatively simple derivative products provide ample capacity for risk transfer. However, increasingly opaque products of rare expertise continue to proliferate. It seems their purpose is only to evade capital restrictions and securities and tax legislation.

  10. this is one of the best financial blogs on the internet. i have to say here that the dollar is going to tank hard in about 5 weeks, so make sure your investments are in now way tied to the dollar.

  11. It really sounds like a whole bunch of fancy terms to tell you that i am selling you the shirt on your back.

  12. One of the great oddities of finance, is that when a non-natural-resource industry becomes commoditized, it generally decreases as a percentage of GDP. Cost of production decreases (unless raw materials are scarce, as in the case of oil fields) due to technological improvement. Yet in finance, we have witnessed it growing as a % of GDP…

    Much was made a decade or so ago about the threat to the wall street investment banks due to online brokerages, which cut off a large revenue stream. Not a few people have argued that this “forced” investment banks into riskier lines of business. Prior to this, much of their revenue stream was derived from the services they provided. When those stable streams were cannibalized by low-cost competitors (e-trade, etc.), they had to rely on either absorbing more risk, or “innovating” to provide new value. The same was argued about the two lines of business that constitute retail banking (fees vs. intertemporal arbitrage – which is selling short term debt and buying long term debt).

    So the brokerage firm solution, we now know, was actually the obfuscation and reselling of risk.

    One empirical point, on which I’ve seen no evidence, is how much of their activity has resulted in a narrowing of the spread between risky and non-risky (but higher return) investments…

    Arguably, if this risk spread has decreased, then they’re doing a good job, and society is benefiting by investing more in high-return/high risk rather than low return/low risk investments (so long as the total risks are tolerable at the social level).

    Yet we have another odd data point… the returns on low-risk investments over the past 30 years have not merely been closer to, but in some cases higher than the returns on high risk-investments. This could merely be bad luck. Or, it could signal a systemic issue with underpricing of risk to the extent that risk (itself) is given positive value rather than negative value.

    I wonder what happens to most of our economic models when risk has a positive value associated with it…

  13. Mr. Kwak quoting Mr. Konczal’s discussion with an investment professional: “he told me that selling people embedded options is always deviously clever because people don’t understand that they are buying them, and often don’t understand their value.”

    The customers don’t understand the value because they don’t understand the risks. Which years ago would have been fine, BEFORE the Gramm-Leach-Bliley Act of 1999, because the customer and their investment bank would have faced those risks. Now because of the Gramm-Leach-Bliley Act of 1999 they push those risks onto small depositors at commercial (or retail) banks.

    Texan Phil Gramm (who went on to work as a lobbyist for the bank industry after leaving Congress) must be so proud. Right up there with the flag and apple pie. Cue the American national anthem please.

  14. I think he means they don’t understand the value of artisan hand-crafted derivatives, prepared with loving care by qualified quants. 10 years from now people will be saying “they just don’t craft them like they used to” and everyone will want to have “antique derivatives.”

  15. Maybe we can pull Dr. Greenspan’s statement out of the archives: “History has not been kind to those who underprice risk.” This from the Ayn Rand-Milton Friedman worshipper who made capitalist risk-apologetics his life work.

  16. I think you mean customers selling options. The banks do this to reduce the cost of products, although full price of the option is not passed along to the customer. This is invariably because the option is not liquid, so the practical price is less than the mathematical price.

  17. “he told me that selling people embedded options is always deviously clever because people don’t understand that they are buying them”

    this is the wrong way round – they are buying options – or rather the mug/client is writing them. cf Expat derivative trader above – HSBC was trying to sell him a proudct which included him writing an option back to HSBC on the settlement currency.

    It’s sort of pedantic but also crucial – its difficult to sell somebody an option because they are unlikely to overpay for something they dont even know they are getting. but it is very easy to slip a valuable option in for them to sell/write when they have no idea of the value they are giving away.

  18. LarryKudlowIsGiddy

    one word – “Plastics”