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derivatives

More derivative witch hunts

November 17, 2009 in Finance

Going through the FT’s original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn’t going to be as easy to understand as SPY. But that doesn’t mean it’s “out to get” investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS?  Now those were truly frightening derivatives – leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC’s are nothing compared to that. In fact, they’re no more terrifyingly complex – and much less manipulable – than the commodity ETFs Alphaville covers so frequently. Yes, they’re the first currency ETFs (sorry, FT insists that it’s wrong to confuse these for ETFs, even though they don’t say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don’t even know where to start with this one. Maybe the author wrote this because the word “collateral” appears frequently in the prospectus. I wonder if it’s the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We’re talking about total return indices on the deepest, most liquid market in the world – not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it’s not exactly a free trade. One of two things must be true:

  1. MS doesn’t want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they “steal” the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
  2. MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they “steal” the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there’s really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: “AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie  Mae and any equity listed on ’specified indices’ anywhere in the world” (and I’m going to hazard that adding “anywhere in the world” is yet more bait, since the “specified indices” are major ones in developed economies). Let’s call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers.  And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends – they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the “potentially illiquid” line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid – they represent claims on FX derivatives! There’s no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here’s a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There’s a third option, which is to buy SPY – effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it’s the swap.) Yes, a TRS is a derivative – but it’s not evil by that virtue. It’s exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let’s not get all suspicious of these crazy methods for replicating payoffs.

I’m not going to pretend that these ETCs are vanilla securities. They carry risks – perhaps large ones – and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven’t read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT’s attitude rather than the securities themselves. I can’t endorse any sort of derivative witch hunt of this sort – its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it’s hardly appropriate here.

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CDS Markets, briefly (or not so briefly)

July 15, 2009 in Finance

In response to Daniel Indiviglio’s call for “someone who understands the derivatives market,” I posted the following comment on the Atlantic Business blog – and I reprint it here not just because it turned out a surprisingly complete thought, but because I’m a glutton for blogging laziness:

The CDS market works similarly to any other market: traders announce prices (privately or otherwise) at which they are willing to trade, and if two traders’ levels agree, a trade may be executed. These levels may be informed by quantitative models, gut feelings, even sheer necessity – but the mechanism by which trades are conducted is quite straightforward: two CDS traders agree to a trade, at which time their respective firms enter a legally binding contract to exchange the necessary cashflows. That part takes place off the desk, however.

There are two predominant forces in the CDS markets – again, as with most markets – the “buy side” and the “sell side”. The buy side refers to those traders looking to place directional bets; they look to trade securities as advantageous prices, hold them for some time, and then sell them at a profit. The sell side, by contrast, is not interested in taking risk; it merely wants to service the buy side and be compensated for doing so. To accomplish this, sell side traders seek to simultaneously buy and sell the same security, capturing the difference in price for themselves and taking no exposure to the security in the process. The market dynamics arise out of this tension – buy side traders looking for “good” prices, and sell side traders seeking to capture a “bid ask” spread. Increasingly, however, sell side traders are starting to resemble the buy side as banks take on proprietary risk (evidenced most recently by Goldman Sachs).

It would appear that most of the regulatory concern with the CDS market is not about *how* contracts are traded, but rather the management of those contracts themselves. The CDS market is an “over the counter” (OTC) market, meaning transactions are executed between two consenting parties rather than via an anonymous exchange. In any OTC market, there is an advantage in being “the counter” – or the sell side. This is because the sell side 1) has an information asymmetry in that they see much more of the market than any individual buy side trader and 2) can adjust their price – even away from the “fundamentally correct” price – to take advantage of the supply or demand they perceive in the wider market. Thus, one of the first regulatory aims is increased price transparency.

A second concern is how each trader’s firm treats the contract after it has been traded. AIG was not required to post collateral on their sold CDS, and consequently was ruined when they discovered they had sold more contracts than they had collateral to back them. Lehman’s bankruptcy locked away funds owed to other firms, because they did not only have exposure to the firm they traded CDS *on*; they had exposure to the firm they traded *with* as well. The regulatory solution to the issue of counterparty risk is to create a CDS clearinghouse, which will standardize all collateral disputes and decrease counterparty risk throughout the market.

Finally, people are afraid that CDS are mathematically complex, difficult to price products – and to an extent they can be. Nonetheless, this fear arises with many derivatives, because they do not trade on an open market and do not represent “pure” parts of the capital structure (as if companies only issued simple stock and bonds in the first place). A response would be that having a mathematical grounding should actually increase people’s faith in receiving an honest price, for in the absence of a highly liquid market, how else can you determine whether a price is fair? Thinly traded stocks may jump tens of percents each day, because there is no price discovery mechanism – and without a grounding in transparent math, who can say what the proper level is? Unfortunately, many attempts to explain CDS veer into complex math simply because they can, not because they need to. CDOs, while more complex, have a similar problem (though I recently tried my hand here).

I believe that these three items: OTC, counterparties, and scary math have greatly contributed to the demonization of CDS contracts. As Petrobull stated, the incestuous nature of many trading desks and sometimes-difficult trading vocabulary only add to the confusion. Moreover, we have seen the concrete and disastrous toll that derivatives can have in AIG and Lehman, among others, cementing (or necessitating the invention of) the error of these market’s ways in our collective psychology.

Indiviglio was last seen on TGR here.


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Yet more reverse convertibles: positive sum games?

June 19, 2009 in Finance

Did Felix Salmon really just write this in defense of his reverse convertibles stance??

For one thing, stocks generally go up over time: they’re a positive-sum game.

…

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game.

I am Jack’s stunned silence.

Felix’s post is an excellent overview of why reverse convertibles are a terrible investment. However it gives no backing to the argument they should be banned rather than avoided. In particular, I don’t follow this logic:

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

Why is it a problem if the transfer of wealth is from client to broker? Since when do people care (or, indeed, even know) whom they face on a trade? Moreover, options are more profitable for brokers simply because they are less liquid; they charge higher commissions, not because of any inherent security characteristic. Indeed, commissions are likely what the last “truism” is premised on, but that seems a stretch to me – like saying on aggregate, baseball fans lose because they buy tickets to watch their team play.

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Wilmott’s stages of derivatives

June 18, 2009 in Finance, Math

Wilmott adapts the Kubler-Ross stages of grief to describe derivatives. An excellent read.

Confused disbelief: I’m a great believer in education playing a bigger role in derivatives in future. But not the sort of education that we’ve got at the moment. I understand Warren Buffett when he says “The more symbols they could work into their writing the more they were revered.” Universities are churning out many thousands of ‘experts’ in the analysis of derivatives but sadly they know more about the math and the symbols than they do about the markets. But again it’s not the symbols themselves that are to blame, for we happily fly on airplanes designed using similar symbols, rather it’s the lack of financial empathy exhibited by the multiple-PhD’d analysts, the quants, that worries me. Remember this is a mathematician writing this, but one who has been saying less is more for over a decade now.

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Reverse convertibles

June 17, 2009 in Finance

Ever since the WSJ published this article on the front page of section C, a lot of people are talking about “reverse convertible notes.”

James Kwak and Felix Salmon led a charge to ban the instruments but Felix, at least, seems to have backed off a little bit after these responses.

I’ve seen many varieties of these notes in the past, and while I would never purchase one myself (I don’t have any interest in ever shorting puts), I know there are many people out there who would – namely, the same people who sell options anyway. Happily, the best analysis I’ve seen is a response to Kwak by Daniel Indiviglio in The Atlantic. To skip the suspense and jump to his close:

It seems to me that truly useless financial innovation will be eliminated by the market already: if it’s not useful, no one will buy it. If you want to regulate to make sure that investors are savvy enough to know what they’re buying, that’s fine. But to eliminate financial products just because bureaucrats don’t understand their purpose seems like a bad idea to me.

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The Short Squeeze

April 30, 2009 in Finance

It is a favorite chorus of the anti-CDS crowd that CDS can make it more difficult for a company to survive, since bidding up CDS prices can affect the firm’s cost of borrowing.

This is about a hair’s width away from the oft-cited argument that “short selling is bad because it drives down stock prices,” a view that has was disproven in a massive 2005 study as well as multiple studies (pdf) showing the recent ban was actually harmful, not to mention market participants ultimately declaring it a failure.

However – in fairness – there is one time where short selling, or taking a short position more generally (such as through CDS), makes an indisputable impact on the underlying security: the short squeeze.

What happens when investment firms that have bought (potentially) limitless amounts of insurance on another company’s debt need to hedge their short position?  They must compete to buy the relatively few tangible assets that can provide that hedge: the company’s bonds themselves. And this bidding war is ferocious. CDS driving a company’s spread wider is a bit of a wags-the-dog situation.  But massive demand for a company’s bonds, that’s real. Moreover, it has been a major driver of the recent credit rally, which in turn fuels the equity run.

The most dramatic example of a short squeeze in action is of course Volkswagon, which gained 500% in one day last fall and was briefly the most valuable company in the world after a massively short investor base suddenly realized there weren’t enough shares to go around (Porsche had conveniently purchased most of them, and would end up booking a profit).  But here’s the key: if short sellers can drive stock prices down, then surely VW – with one of the highest short to shares ratios ever – would have experienced some sort of price depression. But no, the stock hardly dropped in the months preceding the spike.  Instead, this particular example of financial product failure resulted in saavy VW employees becoming millionaires overnight.

One datapoint does not a proof make, but look at today’s credit market, or even the recent equity markets rise on decreasing volume, and you’ll be unable to ignore the power of short covering to drive real asset prices higher.  The market works on supply and demand; derivatives have a seperate market and so do not affect underlying asset prices except to the extent that people use derivative prices to extract risk information which informs their demand for the underlying. But whenever the derivative market and tangible market intersect, look out! If I own an arbitrary number of CDS and suddenly I need bonds to cover, the market’s normal mechanics will be disrupted.  Even the VW example represents a perversion of supply and demand – Porsche was slowly buying up all the shares while other investors were shorting them, restricting supply dramatically. I remember headlines at the time which announced Porsche was actually releasing shares just to placate shorts who needed to cover.

Ultimately, if capitalist markets represent the method by which capital is most efficiently allocated and required returns are most efficiently expressed, then a long-only market is hardly the epitome of that ideal.  But as long as companies can point the finger at “security manipulation” instead of their own performance (expert witness: bank stocks declining despite the short sale ban), we will continue to have this debate.  Not that any company complains when the short squeeze pushes them higher.  Instead, they just issue debt and stock, a behavior which lately has been married to the highest rate of insider selling in year.

So the next time someone tries to claim that CDS, or short selling, can have an adverse impact on asset prices, don’t throw study after study at them which demonstrates otherwise.  Just point out that to the extent their argument is true, it’s effect is much more dramatic on the squeeze side – the upside – than where their complaint lies.

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