May cause insomnia

Alan Kohler | Business Spectator

I don’t know whether to lie awake at night worrying about over-the-counter (OTC) derivatives or not, so I lie awake at night worrying about whether to lie awake and worry.

I should just buy a worry default swap and go back to sleep. But what happens if the counter party can’t pay? Who IS the counter party? And how many trillions of worry default swaps are out there, ready to collapse like an Egyptian block of flats and turn my dreams to nightmares?

The Bank of International Settlements says there are $US681 trillion worth of over-the-counter derivatives in the world, which sounds like rather a lot. Is that more than there are stars in the sky and grains of sand on the beach?

In any case, what does it mean? Should I worry about that number, or is it like saying there were 59.6 billion cappuccinos produced in the world last year. Is that concerning or not?

Last month the Financial Stability Forum (FSF), which was set up in 1999 as an inter-government body to promote international financial stability, solemnly presented a paper to the G7 in which it recommended, among other things, reform of the OTC markets.

It can’t actually do anything, you understand, it’s just a forum. There is nobody who can actually do anything. We can invade Iraq and tortuously negotiate rules to stop global warming, but each country is on its own when it comes to derivatives.

The FSF recommended: “the financial industry should develop a longer-term plan for a reliable operational infrastructure supporting OTC derivatives”. It went on to explain that the infrastructure should capture all trades, deliver reliability and scalability, maximise efficiencies from automation, enhance the management of counter-party risk, address all asset classes and encompass both dealers and investors.

You know what that sounds like? A securities exchange. That’s right folks, the Financial Stability Forum says the way to improve OTC derivatives is to make it work like a public securities exchange.

OTC trades are carried out between two parties in private. I say to a bloke in a pub: “Would you like to buy this Rolex watch?” He says: “Sure, how much?” I say: “Ten bucks”. He says: “That’s way too much for a Rolex.” We deal at $7.50. That’s an OTC transaction.

If I say: “Would you like to buy a Rolex watch next week?”, that’s an OTC derivatives contract, in this case futures.

Credit default swaps (CDS) are where someone agrees to pay me if someone else I’ve lent money to can’t, because they’ve gone broke.

A contract for difference (CFD) is where I bet that an exchange-traded item, namely an ordinary company share, will go up or down, and you bet that it will go down or up. And we both sit there watching the stock exchange screen tensely and then when the stock moves, one of us goes “HAHAHA, I WIN” and collects money from the other one.

That’s why OTC derivatives are worth US$681 trillion – because they’re so much fun.

The most fun of all is had by investment banks because they get to collect lots of fees and don’t have to tell anyone about what’s going on. There’s no regulatory pests meddling in the free market and trying to get them to report the trades or charge less in fees and interest.

For example there are two ways to trade CFDs in Australia: OTC and on the ASX. On the ASX it’s transparent – you can look up the prices on public screens, the interest rate is 1.5 per cent over cash (versus 3 per cent over in most OTC deals) and there’s no other fees. OTC CFD dealers charge a variety of hefty commissions for their trouble, on top of the interest rate and sometimes on top of a widened spread.

What’s needed is a Kyoto protocol for putting all of the world’s OTC derivatives trading onto public exchanges.

No more private deals with investment banks doing what they like with CDSs and CFDs on the QT.