Saturday, March 20, 2010

They did it again


Last weekend it was quantitative trading. This time it’s derivatives. The March 4th posting discussed putting derivatives on exchanges. Well, Baron’s again provides a very good elaboration on the issues surrounding derivatives in “The Case for Regulating Financial Derivatives” ( ). It presents some relevant data. It’s worth reading. Last weekend I didn’t bother to nit pick regarding the issue on quantitative trading. But, this time there is a point worth noting. It is worth noting because it is a question of fact. There are other issues regarding policy detail where readers can reach their own conclusions.

Let me again point out that the article is worth reading because this is really nit picking. The article implies, almost states, that regulators didn’t know of the risks imbedded in the derivatives market. That overstates the case, at least as it relates to the New York Fed. My impression was that the New York Fed was concerned because that they did know the risk was there. That concern was heightened by the fact that they didn’t have the data to quantify it or to ascertain who bore how much of the risk.

My impressions may be easy to dismiss, but, remember, the New York Fed had been through Long-Term Capital Management and the October 1987 stock market collapse. They knew the risk first hand. Further, there are speeches and articles to that effect. The author of the article even points out that the Fed had been working on “modernizing” derivative markets since 2005. If you want an example of revealed preference (that’s economist speak for placing your money where your mouth is or acting on your beliefs) here’s one. They hired away an economist from a former employer after he wrote a very insightful article highlighting the risk.

When referring to regulators who didn’t see the risk, the author of the Barron’s article may mean regulators more concerned about K Street than Wall Street. That has certainly been the case. But, more importantly, the article Baron’s spells out the argument for exchange trading quite well.

If one prefers a book format, A DEMON OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL INNOVATION, by Richard Bookstaber is appropriate. However, I found it too preachy. It also seemed to be too focused on hedge funds. But, one can’t argue that he wasn’t onto something, and the tone may be justified by the seriousness of the topic. Written in 2007 it was certainly timely. Its sales may have been hurt by the fact that shortly after it came out, one didn’t need the book. Its thesis was playing out real time in the national media.

By contrast, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT, by Roger Lowenstein was a pure delight to read. It was written in 2000. The fact that it was written seven years before Bookstaber’s may explain Bookstaber’s emphasis on hedge funds.

Either book can be read for fun as a financial market “who-done-it.” Lowenstein’s works best as a “who-done-it.” Bookstaber by contract is more explicit about the connection between the risk imbedded in complex derivatives and liquidity.

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