CCP “contagion” fears spark derivatives debate

Controversy over the handling of derivatives dominated talk at the Mondo Visione Exchange Forum this week, where panellists contested the value of interoperability and whether CCP contagion might bring down the financial system.

“Regulators should absolutely not allow interoperability for derivatives,” said Philip Simons, head of OTC derivatives business at Eurex Clearing. “It creates systemic risk. If one clearing house goes down, it would result in contagion as it would bring down all the others. CCPs are phenomenally under-capitalised. They could easily fall over.”

Simons added that although models predict that the financial system is currently relatively ‘safe’, the events of 2007, 2008 and 2009 should serve as a serious warning not to become overly complacent. Despite having some of the best technology and staff available, companies such as Lehman Brothers failed to protect themselves against systemic risk. The models that suggest interoperable CCPs for derivatives could work may also be wrong, he said.

This site has as good a definition as any, along with a video titled, 'What is a Derivative'.

Put simply, Derivatives are profit instruments created out of thin air as a result of no oversight in the system. The main culprit behind the 2008 crash, Mortgage Derivatives, should never have been permitted.

As proof nothing has changed, anyone can turn on a TV and watch a commercial or news story about how 'housing prices have "recovered"'...aka, "the bubble has returned". That "bubble" is absolutely necessary to preventing the crash of all the GSEs (government sponsored enterprises), for which the Dem Congress removed the cap for bailouts...currently at over $250 Billion.

The finance & real estate yahoos all want us to think everything is 'ok', but the reality is we're all on the precipice, imho. This article is about an accounting trick. The government bailed out the GSEs to the tune of over $350 Billion by some accounts, but no one can explain how debt on private residences generates real income when a house is more equivalent to a 'security' than a 'commercial investment'...the latter of which actually DOES produce a measurable ROI (return on investment)...funny how we ended up with all that debt if houses actually generate income and residential equity has any basis in fact. /s

The Real Estate Market is a house of cards, imho, and the 2008 crash was proof. The deeper causes (Dem policies) are all pretty much history. Due to our GDP being dependent upon consumer spending and home-buying, is it any surprise we're being fed BS on this as well?

That's my understanding; someone else correct me if I'm in 'left field'...

Regardless, what's missed is this article is about European problems with derivatives (CCP defined), not the US. It's been 7 years and the EU is only now implementing European Market Infrastructure Regulation (EMIR) to fix their problems, which were based on US derivatives trading. The article states

Simons added that although models predict that the financial system is currently relatively ‘safe’, the events of 2007, 2008 and 2009 should serve as a serious warning not to become overly complacent.

and, imho, that is telling.

A derivative is a contract between two parties, where the value is driven primarily by the price of some underlying physical “thing” like oil, gold, or a stock. The best known derivatives are futures (where you are buying with an execution/delivery date in the future), options (the right but not obligation to buy or sell), and swaps (exchange of two cash streams). Even a sports bet can be thought of as a derivative, as the value is based on something else.

Using the sports analogy, let’s say you want to buy Pats/Colts (i.e., buy the Pats, sell the Colts). The spread is 7, so you would pay $7 and receive in dollars the difference in the score.

Collateralization is a process where the two parties to the contract “settle up” the current value on a daily basis (this is called “marking to market”). In the betting example, you paid $7 to enter into the contract, but the current market value is $7, so I would “post” that amount back to you.

Then, later in the day, ESPN breathlessly reports that Tom Brady has a hangnail, and the spread falls to 3 points. That means your contract is only worth $3 by current reckoning, so you need to return $4 of the collateral I posted.

On Saturday, Andrew Luck sees a GEICO ad and gets really mad, and guarantees a win, causing the spread to go to 2. Now your contract is only worth $2, and you return another $1 of collateral to me.

Then on Sunday, the Colts get Gronked and lose by 18. The contract settles at $18, and since I’ve already posted $2 I need to pay you $16. (I really hope I haven’t screwed up the math somewhere.)

Of course, if I only have $10, then I can’t pay, and you don’t get your money. This is called counterparty credit risk. If my buys and sells are mostly balanced, it’s not much of a problem, but if my position gets too directional I can be exposed. Alternately, if I have very directional risk facing a counterparty who goes under, then we can start to see contagion.

Enter the central counterparty. After you and I make the initial bet, we agree to amend the contract (”novate”) so that the CCP sits in between us, i.e., your long Pats/short Colts position is against the CCP, and my offsetting position is against the CCP. So the CCP is net flat. Two additional bits of information: we will each post a little bit of extra collateral to the CCP (so on day 1, instead of getting the full $7, maybe you only get to hold $5, and instead of posting just $7, maybe I have to post $9, so the CCP holds net $4); and, if I go under, the other market participants are not affected (for the most part — there will be some market disruptions due to the need to “replace” the risk that evaporated, to restore balance to the system).

Hope that helps.

I read that definition. So, if one owns for example a real estate derivative, they don't actually own any real estate, just profits off the mortgages? Is "bundling" different, because the bundle is actually a collection of real estate deeds? (correct me where I'm wrong)

If I'm understanding this correctly, I don't see where it's any better than becoming a really good card player and going to a casino. At least in the casino I'd have some control over how the game is played.

I have a simple mind that just wants to understand the basics and proceed analytically from there. I'd rather have "stuff" of value...a deed to my house and car, maybe some easily verifiable silver bullion, actual in my name stock shares,....

Yes, that helps somewhat. I'm going to read it over, slowly, at least three times today. I won't even look for errors, your numbers get the give-and-take across. It does sound like a bit of a Monopoly game, where I buy a derivative on say a hotel on Boardwalk according to a present value, but the price of that hotel fluctuates day to day, and I give or get money accordingly. That would really mess up the game, especially if people had the means to manipulate the value of a hotel on Boardwalk.

How could a derivative not be subjected to cheating? If I wanted to lower that spread on a Pats game, I'd start a well placed rumor that Tom Brady couldn't play in that game....(etc)

This really shouldn't be allowed; it does sound like gambling where insider knowledge and manipulation win the day.

Put simply, Derivatives are profit instruments created out of thin air as a result of no oversight in the system.

Wow, bad definition. Derivatives have been around for a long time. Grain futures on the CBOT are derivatives. So are options on the CBOE.

The main culprit behind the 2008 crash, Mortgage Derivatives, should never have been permitted.

Wrong again. MBS are bonds, not derivatives.

Here's a decent definition.

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks.

Futures contracts, forward contracts, options, swaps and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is "derived" from that of the underlying stock.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security. For example, a trader may attempt to profit from an anticipated drop in an index's price by selling (or going "short") the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract.

For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance." The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have.

Some derivatives are traded on national securities exchanges and are regulated by the U.S. Securities and Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC); these derivatives represent individually negotiated agreement between parties.

http://www.investopedia.com/ask/answers/12/derivative.asp

I’ve read those explanations. I’m sure you believe it. I do NOT.

Mortgage backed securities are a class of derivatives since the owners of these bonds derive the return from the payments on mortgages, but do not actually own the mortgages.

This subject is fraught with hyperbole. I’m afraid all this discussion is doing is confusing those reading it looking for clarity. There is no clarity, only obfuscation & hyperbole by those seeking to protect their fictional profit instruments which, of course, resulted in all the debt.

We could have a conversation about where much of the $$ went (IMHO), but I’d only piss off a bunch of people. Nobody wants to hear it. The proverbial ostrich is the order of the day and our enriching politicians are duty-bound to fix it all. /s

Rumors affect both the underlying instrument and the derivative. If there’s a rumor that a company is going to be taken over, the share price will jump. If there’s a rumor that a storm is coming, there will be a run on the grocery store. If there’s a rumor that Tom Brady won’t be playing, prices for tickets on StubHub may fall.

Derivatives allow proxy hedging for illiquid holdings. If I want to refinance my mortgage at current low rates, but due to liquidity or scheduling or whatnot I can’t, I can still trade some other interest rate product (like a bond future) so that if rates rise I’ll make money to make up for the higher rate I’ll pay on the mortgage. There will be some costs involved (transaction costs), and the profit/loss on the hedge won’t be exactly equal to the impact on my mortgage (basis risk), but if I size it appropriately the impact will at least be kind-of, sort-of, right-ish.

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