“The Derivatives Dealers’ Club”

By James Kwak

Robert Litan of Brookings wrote a paper on the derivatives dealers’ club — the small group of large banks that control most of the market for certain types of derivatives, notably credit default swaps. It’s a blunt analysis of how these banks can and will impede derivatives reform in order to maintain their dominant market position and the rents that flow from it.

I haven’t had time to do it justice, so I recommend Mike Konczal’s analysis in parts one and two (but particularly one). As Konczal says, “In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have.”

And note that Litan is no bomb-thrower; most recently he mounted a defense of most financial innovation (my comments here).

20 thoughts on ““The Derivatives Dealers’ Club”

  1. It is very clear that 5 institutions are responsible for most OTC derivative origination. A good question would be “why?” If they are SO lucrative and inefficiently priced, some new business should enter the market and help drive down the prices (that’s what Adam Smith would say, anyway). What is the barrier to entry? Massive balance sheets (so you trust your counterparty)? Collusion with rating agencies (who grade new entries poorly, driving away business)?

    Registered exchanges might solve some issues of barrier to entry. Would it solve all of them?

  2. A view from Europe: The wind seems to be turning on that issue, between Gary Gensler’s positions and various European proposals, the latest from the French Finance minister,to set up clearing houses in Europe for derivatives.
    The European Commissioner on the matter, another Frenchman, Michel Barnier, seems to be standing on the
    same line, enough to receive personal letters from Timmie…

  3. I think an exchange would be the first step towards transparency and making the market more efficent. But you also have to remember that because the items are and have been sold OTC, it’s difficult to really assess ‘what is what’ and ‘who holds what bag.’

    Not to mention the repeal of the FASB rules… first accounting for the derivatives (size, position, and quality), then doing some old school accounting would help, bringing them into the marketplace (exchange), and then gradually bringing them onto the balance sheet as the exchange expands to accomodate.

    Of course some of the derivatives are just toxic, non performers, it’s this sort of capital loss everyone is desperately trying to avoid.

  4. Sigh. I guess it would be too much to ask for a paper that discusses competition in a given market to actually include some market shares.

  5. engineer27 wrote”

    “…5 institutions are responsible for most OTC derivative origination.”

    The Gods Must Be Crazy

    “Xi and his band of San/ African-Bushmen relatives are living well off the land in the Kalahari Desert. They are happy because the gods have provided plenty of everything, and no one in the tribe has unfulfilled wants. One day, a glass Coke bottle (CDS Credit Default Swaps/”OTC derivatives”) is thrown out of an aeroplane and falls to earth unbroken.

    Initially, this strange artifact seems to be another boon from the Gods—-Xi’s people find many uses for it. But unlike anything that they have had before….. This exposes the tribe to a hitherto unknown phenomenon, property, and they soon find themselves experiencing things they never had before: jealousy, envy, anger, hatred, even violence.”


  6. “Despite the film having grossed over $100 million worldwide, Nǃxau reportedly earned less than $2,000 for his starring role.”

  7. While it is a funny film, what does it have to do with five banks doing the majority of OTC derivative origination?

  8. This post is a little short, but I think we can forgive the hard-working law student and family man. I’m sure Konczal does a superb job as he does 99.9% of the time.

    I’m watching the PBS’ “Frontline” special on healthcare now. It’s so depressing sometimes. I think if it wasn’t for the few guys like James Kwak, Simon Johnson, Konczal, Felix Salmon (who was absolutely terrific on Jim Lehrer’s “NewsHour” tonight) and the occasional cheap bottle of wine, I’m not sure if I could look at the future of America now. Oh well, keep fighting and praying I guess. I still believe in Obama, but it’s discouraging sometimes. But I still have strong faith in Obama.

  9. I think someday Chuck Grassley will have to answer to God for his stance on healthcare. I honestly believe that. And I hope Grassley has a good answer, even I strongly dislike Grassley and have zero respect for Grassley as a man, I hope he has a good answer to God for destroying what could have been a better bill. Talking about healthcare now, sorry.

  10. Dumb and getting Dumber.
    I understand a little insurance for the occasional default etc.

    However you just have to wonder it the whole idea having to buy insurance to protect your investment/banking strategies isn’t just a BIG F—ING
    indication of a problem that ought to be dealt with by who ever granted the damned loan.

    Oh wait was that the problem??

    Outlaw that and listen.
    Just pretend to think about outlawing and listen. }:-).

  11. AJ,
    I think they have discussed this in the Bloomberg internet articles. But it basically gets down to a big 5 pulling together as an oligopoly or really like a “cartel” to keep those high margins for those 5 dealers.

    That is somewhere online and if you want I’ll try to find that later tonight and post it in the below comment thread. But it’s kind of a moot point.

  12. Mr. Abrams (nice Irish name, wink),
    In the old days they would have fired the loan officers, but then the bankers couldn’t package/sell CDOs and Swaps betting on those CDOs and then getting the American taxpayer to buy the losers drinks and offer them a free hotel room to stay and start the whole game over again.

  13. Mr. Abrams,
    But watch, someone like Peter Wallison, Arnold Kling, or Glen Beck come here and blame it on the Community Reinvestment Act. “It’s those damned uneducated ‘darkies’ taking advantage of the Republicans again!!!” they’ll say….. And the frustrated whites in states like Oklahoma and Alabama who barely got their High School diploma and will have their first toothbrush at age 30 proclaim “See Billy Bob!!! I told you it was themd thar darkies!!”

  14. There will be no “last man standing” when the banks derivatives positions are unwound. Why? Lets say you are “short” and your counter party goes bust. Who are you going to collect from? It want be the clearing house or the exchange.

    Who is pushing the derivatives markets around? Forget the OTC markets. It’s happening on the commodity exchanges like the CME, ICE and others here and foreigh. See http://www.reuters.com/article/idUSTRE63D57U20100415

    Lehman nor any other house has any business traading such things as Energy options, foreign exchange, interest rate futures (US Govt securities), or even agricultural commodities. {I’ll bet they trade by heavy leveraging using “hedger” margin requirements.}

    All this is, is wild casino type speculation. We need to do away with all devivatives trading, the CFTC, the FTA and the exchanges such as CME and ICE. Send them all overseas and get them out of the U.S. Treasury’s pockets.

  15. Litan’s discussion of financial innovation is fine until he gets to CDSs, which he clearly does not understand. He claims there are 42 trillion outstanding of which only 1% cover mortgages. I wonder how he might explain how this produced a $23 trillion (and counting) problem for the Fed?

  16. I should have read the Konczal links originally, which at least attempt to give some shares.

  17. Could the Glass Stegall Act be updated and address the needs and requirements to re-regulate Wall Street
    Keep it simple and effective.

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