Tag Archives: Traders Guns & Money: Knowns and unknowns in the dazzling world of derivatives

The EU End Game: Regaining Control

It is one week left before the top leaders of the European Union get together in Brussels for their most important meeting so far. The European debt problems has to be solved; at least a realistic plan that every member state can accept has to be put on the table. The outcome of next weekends summit will determine the future of the union. It’s make or break time. This the first of a series of articles focusing on possible solutions – this is the final countdown.

“The EU ban on naked sovereign CDS may be a signal that regulators and legislators now understand the issues and are prepared to address them, bringing about meaningful reform in the control of derivative trading.”

Satyajit Das


“Predictably the EU ban on “naked” credit default swap (“CDS“) contracts on sovereigns has brought forth an angry response from dealers and the industry body ISDA (International Swap & Derivatives Association). Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers,” Satyajit Das at eurointelligence.com

writes.

The EU leaders have lots of important issues to discuss next weekend, but we have to start somewhere so why not with the new regulations and the demonized Credit-default swaps?

Former derivative trader  Satyajit Das with the eurointelligence.com knows what he’s talking about.

Here’s Mr. Das proposal on how to deal with the problem:

The familiar case was that prohibition was unnecessary, would decrease liquidity, increase borrowing costs and create greater uncertainty for European firms. The arguments are self-serving and do not present a balanced view of the issues.

The EU rule does not impede genuine hedging. If an investor owns sovereign securities or a firm has receivables that rely on the sovereign directly or indirectly, then purchasing protection using a CDS is permitted.

ISDA argues that banning naked CDS would have a detrimental effect on individual country’s borrowing costs. An EU study that found that the sovereign CDS market was small relative to the size of underlying bond markets and had negligible effect on credit spreads. Given this evidence, it is puzzling why banning these contracts would somehow affect pricing.

The real issue is that a ban on naked CDS on sovereigns is seen as the “thin end of the wedge”, ushering in greater control on the size of the derivative market, limits on the purposes for which derivatives are used and also on the types of derivative contract permitted. Given the substantial derivative trading profits earned by major dealers, ISDA’s position is predictable.

Historically, CDS contracts were used for hedging. Buyers of protection used these contracts to hedge the risk of default of a firm or country. CDS contracts avoided the need to transfer loans or sell illiquid bonds. It also allowed greater flexibility in hedging and offered ease of documentation. Investors could sell protection to acquire credit exposure, especially advantageous where there was no liquid market in the borrower’s bonds.

Over time, speculative factors came to drive the CDS market. The ability to short sell credit became more important. Buyers of protection, where they did not have any underlying exposure to the issuer, sought to profit from actual default or deterioration in its financial position.


Sellers of protection used CDS contracts for leverage. Selling protection on an issuer required minimal commitment of cash (other than any collateral required by the counterparty). In contrast, purchase of a bond required commitment of the full purchase price.

As trading was not constrained by the physical availability of bonds or loans, the CDS markets were more liquid than comparable bonds, facilitating trading.

The shift from hedging to speculation improved liquidity but at the cost of increased risk. The global financial crisis exposed the complex chains of risk and the inadequate capital resources of many sellers of protection.

ISDA’s argument that a ban on naked sovereign CDS will adversely affect Europe’s financial stability is disingenuous. Speculative trading in sovereign CDS is likely to be more destabilising, allowing potential market manipulation.

In practice, sovereign CDS volumes are low and large traders can influence prices, which frequently affect the values of bonds as well as CDS contracts. Commenting on the problems of AIG’s CDS positions, George Soros accurately stated the true use of these contracts: “People buy [CDS] not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. AIG thought it was selling insurance on bonds and, as such, they consider CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.” [George Soros “One Way to Stop Bear Raids” (23 March 2009) Wall Street Journal].

The response of the industry to the EU proposal reveals that participants are unwilling to admit the unpalatable realities of derivative trading. Much of what passes for financial innovation is a vehicle for unproductive speculative activity, specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The aim is to generate profits for dealers.

The EU ban on naked sovereign CDS may be a signal that regulators and legislators now understand the issues and are prepared to address them, bringing about meaningful reform in the control of derivative trading.

By Satyajit Das

www.eurointelligence.com


Satyajit Das is a former derivative trader, now author of “Extreme Money: The Masters of the Universe and the Cult of Risk” (Forthcoming in Q3 2011) and “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”  (Revised Edition – 2006 and 2010).

Read also Satyajit Das’ 3-part analysis of the European economy and debt crisis:

Related by the Econotwist’s:

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Currency: The Weapon of Choice in Trade Wars

During the European debt crisis, in a matter of days, the dollar strengthened by around 10%. The weakness of the Euro and resultant appreciation of the Renminbi by over 14% reduced Chinese exporter’s earnings and competitiveness. Some of the moves reversed equally quickly when markets stabilised. Volatility of currency exchange rates has increased markedly in recent months.

“The US dollar has no enemies, but is intensely disliked by its friends, especially key investors like the Chinese.”

Satyajit Das


“To paraphrase Oscar Wilde, the US dollar has no enemies, but is intensely disliked by its friends, especially key investors like the Chinese,”  author Satyajit Das writes in a blog post at the EUROintelligence.com, Monday. “The Euro is now the “Drachmark”  – a derisory combination of the former Greek Drachma and German Deutschemark,” he adds.

The former trader, and author of the “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives,” goes on:

Investors assumed that the Euro would be a new Deutschemark, supported by German commitment to fiscal and monetary rectitude avoiding Gallic and Mediterranean extravagance. Instead, investors have been left holding a currency underpinned by unexpected German extravagance and Gallic and Mediterranean rectitude.

Despite sclerotic growth, public debt approaching 200% of GDP and a budget where borrowing is greater than tax revenues, the Japanese Yen has risen to its highest level against the dollar in 15 years. China is even switching some of its currency reserves into Japanese government bonds with returns only apparent under powerful electron microscopes.

Fears about the value of any currency have seen a resurgent interest in gold. Traders are now reading their John Milton: “Time will run back and fetch the age of gold.”

Amongst currencies, it is simply a race to the bottom. On 27 September 2010, the Brazilian Finance Minister Guido Mantega stated the obvious speaking of an “international currency war” as governments around the globe compete to lower their exchange rates to boost competitiveness.

Arcane currency shenanigans point to deeper, unresolved economic issues that policymakers are unwilling or unable to confront but whose resolution is crucial to a sustainable recovery and growth.

Since the end of the de facto gold standard and Bretton Woods, currencies increasingly have become weapons of choice in trade and economic wars. In the German and Japanese model of economic development, an undervalued currency is a key mechanism for maintaining competitive costs and high levels of exports to drive growth. Successive generations of emergent countries, most notably China, copied the model.

Despite tensions, the model worked well in a world of strong economic growth and increasing trade. It was a question of dividing growing wealth. The model is more problematic in a world of low growth.

Currently, the world may be entering a period of lower growth. Consumer spending, funded in developed countries by debt, has slowed. Given significant over capacity in many industries, business investment is weak. Under increased pressure from money market vigilantes, governments are cutting spending and raising taxes, embracing the “new austerity”.

As growth slows, maintenance of competitiveness requires businesses to manage costs brutally.

Cheaper currency values assist in remaining competitive, avoiding the need to overtly cut costs by reducing wages or cutting benefits, explicitly lowering living standards.

During the global financial crisis, the repeated manoeuvring of China, Japan and Germany to maintain the low value of the Renminbi, Yen and Euro against the dollar was designed to maintain export volumes to cushion the worst effects of the recession.

To a large extent, it reflects the underlying structure of economies heavily geared to exports.

Angela Merkel has repeatedly stated that she sees no change to the export driven German economic model in the near term. For Japan, falling living standards combined with an ageing, falling population means increasing dependence on exports.

For China, increasing wages pressures and domestic inflation means that rising production costs must be offset by other means, including an undervalued currency.

The problem of shifting models is great. In 1985, the Plaza Accord forced Japan to effectively revalue the Yen, setting off a rise from Yen 230 per dollar to Yen 85 per dollar.

The rise in the Yen reduced Japanese export competitiveness and led to a recession. To stimulate the economy, the Bank of Japan and Government pumped large amounts of money into the economy.

Rather than assisting recovery, the money set off a commercial real estate and stock market boom that collapsed spectacularly at the end of 1989 plunging Japan into the “ushinawareta junen” – the Lost Decade.

Aware of the Japanese experience and at risk of repeating the experience, China has fervently resisted revaluing its currency, despite pressure from the US. Recently, Chinese leaders have spoken about the economic and social catastrophe that would result from a major renminbi revaluation.

Chinese Premier Wen Jiabao told an European business conference that: “If we increase the yuan by 20 percent-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil. If China’s economy goes down, it’s not good for the world economy.”

In order to forestall, European calls, led by French President Sarkozy, for a revaluation of the Renminbi, Wen cunningly voiced support for Chinese purchases of Greek debt.

Wen urged Europe not to “join the choir to press China to allow more yuan appreciation.”

The unstable currency order creates distortions, frequently preventing action to deal with economic problems. It leads to countries pursuing odd and sometimes contradictory policies.

For example, financial triage, cutting the unsustainable and unlikely to survive countries out of the Euro, would restore their competitiveness through devaluation. But Germany is unlikely to allow weaker countries to leave the common currency precisely to avoid a sharp increase in the value of the Euro, making its exports less competitive. Contrary to popular view, the Germany has much to lose from changes in or abandonment of the Euro.

Recent German economic performance has benefited from the effects of a stronger Yen relative to the Euro making its exports more competitive. German corporate profitability has recovered strongly to pre-crisis levels.

More recently, Japan has intervened in currency markets to prevent the Yen testings its 1995 high of Yen 79.75 against the dollar.

Interest rate policies pursued, in part, to manage currencies also perpetuate economic dislocations.

Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars during periods of European instability pushes down interest rates on U.S. government debt. Paradoxically, lower interest rates reduce pressure for deficit reduction by lowering the cost of servicing public debt.

Major reserve currencies, like the dollar, Euro and Yen, provide some ability to offset changes in value by invoicing trade in their own currencies. Unfortunately, for minor currencies, the fact that trade continues to be denominated in the major currencies creates difficulties where a one day move in foreign exchange markets can wipe out the entire profit margin.

The higher volatility means that the cost of hedging the risk of such currency moves is large, reducing profitability.

The currency crisis highlights the “beggar thy neighbour” policies pursued by many economies. China, Japan and Germany have consistently pursued policies that emphasise high domestic savings, low domestic consumption and an undervalued currency to drive its export driven economies.

These global imbalances contributed significantly to the current financial problems.

A global economic order where a few countries save and lend to finance their exports while other countries act as consumers of last resort is unsustainable.

A system where each country seeks to maximise its own competitive position and financial security at the expense of trading partners is not viable.

 

Satyajit Das

 

An emerging toxic combination of inflexible global currency arrangements, a destructive cycle of currency devaluations, trade restrictions and the need of governments to rein in spending to balance budgets is reminiscent of the 1930’s.

.

They threaten a period of prolonged global economic stagnation.

The globalization of complex financial relationships, much lauded before the crisis, is now proving a liability in resolving the crisis.

Optimists must rely on Israeli politician Abba Eban’s observation that “History teaches us that men and nations behave wisely once they have exhausted all other alternatives.”

By Satyajit Das

Related by Econotwist’s:

EU’s Bank Rescue Turning Into Political And Economic Catastrophe

QE Expectations Continues To Fuel The Risk Rally

Commodities: Dollar Movements And QE2 Sets The Agenda

Credit Wrap: The Spectre of Mercantilism

A QE Fixation

Japan Struggle To Weaken Yen

The Ultimate Trading Weapon


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Filed under International Econnomic Politics, National Economic Politics