Thursday, September 2, 2010

Credit default swaps.....Just like Vegas!

What if, what if, what if..........                                                          
What if the safety blanket were 12" underneath the picture!

Then no one gets hurt, of course; but we the casual observers don't know that.

And that, ladies and gentlemen is how credit default swaps are traded! Rightly or wrongly, he who has the greater picture and the ability to legally disguise the outcome always has been, is now, and always will be, the winner.

If that sounds a little contrary, consider that under existing SEC rules neither of the parties in the trade need be the guy on the tightrope, so that anyone gets to play the game if they have the nerve. Just like Vegas, really.

The market's justification for this? The same tired old argument of creating market liquidity to enable efficient deployment of capital.... strictly,of course, for those with VERY short memories!

Lest we forget: Liquidity curves become parabolic exactly because of capital flights which are every bit as likely as orderly flows, especially in a fast paced trading environment. Add in the ability to create 'interest' in an outcome when there is inherently none, and the parabola effect is multiplied to the extent of the additional liquidity infusion.

In plain English. Everyone can bet on what they want, and everyone can trade with the bookies - and this will all work great as long no one has to wind up their position without having enough cash to cover it.

Oops.......not so likely, after the SEC agreed in 2004 to the Net Capital rule which increased the overall leverage of the "Big Five" Wall Street brokerage houses to an average of 33:1 within 18 month. Yep, the same guys making the book.   

What has all this to do with Risk Management? Well, rather a lot actually. 

Perhaps if the traders had:

1. Looked beyond the picture and considered that the security of their counter parties (ie the blankets under the tightropes!) were potentially as frail and exposed as they were
2. Understood that covering their own positions could only happen with liquid assets unrelated to the market that triggered the need in the first place.     

......then much market volatility could have been avoided.

But human nature won the day. Mans need to get ahead of man for the immediate win will always instigate the Parabolic liquidity trap in any market unless order exists alongside the free flow of information.

The former implies much regulation, the latter that all trades are made with equal knowledge - both counter intuitive to the concept of freely competitive markets. Let's see our Global brains trust dig us out of this one. If the CFTC rules being written to regulate OTC derivatives as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act truly engage and compel markets to properly assess risks before their impacts occur, maybe just maybe history will not once again repeat itself quite so soon.      

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