The negative reaction by many in the financial industry to this New York Times article critiquing the structure of over the counter derivative markets motivates me to make a very simple point: Economic theory makes it clear that there is no reason to believe that trading activity will be socially beneficial when the market structure is as described in the article.
Elementary economics tell us that in order for the invisible hand of the market to work, pricing (including bids and offers) must be transparent. That is, economics is explicit that it is only where there is public information about prices that self-interested behavior is socially beneficial or that the ability to make money on the market is an indicator that a valuable service is being provided to the economy. [Ask any economist to explain a competitive equilibrium to you and you will find that good price information is a necessary condition for “first-best” social welfare to be achieved.]
Because transparent pricing is a pre-requisite to market trade having positive implications for society as a whole, if economists ruled the financial world these would be the foundational principles of the marketplace:
1. [Enforceability of pricing regulations] In general contracts that are not traded on SEC or CFTC regulated trading forums are unenforceable. (Note that this is a revitalization of the reforms enacted during the Depression by the passage of the Securities Exchange Act and the Commodities Exchange Act. Note also that I recognize the need for limited exceptions to this rule.)
2. [Price transparency pre-trade] Best bid and offer prices posted by market makers and other traders on all trading forums are publicly available in real time. Market depth information is also publicly available in real time. The cost of providing this data to the public is covered by a fee proportional to trade on the market (e.g. a penny per $100 traded).
3. [Price transparency post-trade] All completed trade data (item, time, price and quantity) on all trading forums is publicly available.
4. [Meaningful prices] All bids and offers have a minimum duration of one minute.
Synthetic Assets 
Elementary economics tell us that in order for the invisible hand of the market to work, pricing (including bids and offers) must be transparent.
That article, and your post, made me wonder: what market are you thinking of in which bids and offers are not ‘transparent’?
CDS traders may send out dozens of runs a day. The runs consist of (drumroll) bids/offers. Anyone participating in these markets can therefore see or at least learn the bid/offer, and can compare with other dealers, etc. Why do you, and the NYT author, seem to think they don’t/can’t? What am I missing?
Maybe there’s a subtler point to make – for example, one might ask how ‘tradable’ are those runs. Or, one might ask if every matched trade executed was at the indicative bid/offer last sent out (answer – course not; in fact, the bid/offer spread will often in fact be *smaller* if the trader really just wanted to facilitate the trade). It’s not clear that the NYT article or this post are working on that level however.
This is not to say that all your ideas are bad or worth resisting. Some I might actively favor. It’s just that they are solutions to a problem whose existence I haven’t even seen established yet.
Clearly you know more about the details of CDS trading than I do. And it is possible that for insiders like yourself the market seems to function well. But I suspect that insiders on NASDAQ were saying the same thing a decade ago.
Furthermore, pricing can not be transparent if it’s not publicly available. Why is access to CDS prices restricted to traders in the CDS market? It’s seem pretty obvious that anybody who trades the stock market will be interested in real time CDS prices. So, no, I don’t think that you can claim that bid and offer prices on OTC markets are transparent.
And it is possible that for insiders like yourself the market seems to function well.
I’m not even sure I know what ‘function well’ is supposed to mean in this context. ‘Well’, relative to what? What are we trying to measure here? What is being deemed deficient? Generally, what is the problem you think you’ve identified (is there one)? I failed to identify one in the NYT article.
Furthermore, pricing can not be transparent if it’s not publicly available. [..] So, no, I don’t think that you can claim that bid and offer prices on OTC markets are transparent.
Ok, granted. I think I had misunderstood/misread how you were using ‘transparent’. To me, they are transparent to anyone who actually participates in said market. It’s just that this isn’t everyone. (Nor should it be.)
You are positing that spread (bid/offer) info needs to be readily/easily available to the public, not just actual market participants, for the market to be said to function well. I’m not sure why that would be. But I’ll grant that it’s probably hard for a layperson to get their hands on CDS bid/offer spreads.
Sometimes I think people reason about CDS by analogizing them to equities too closely. But CDS are not like equities in very fundamental ways. They are not securities but contracts, and they create liabilities, with the cap requirements/margining that entails. So I don’t quite understand what a layperson would do with CDS bid/offer info if they had it. Again, CDS by their nature can’t be entered into by a layperson, and there are perfectly defensible reasons for that.
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re: what does “well” mean?
From the economists point of view it means that there is sufficient competition (or little enough cooperation/leader-follower behavior across market players) that no profits are made over and above what would be made if there were a competitive market. I’m not saying that I know that the big banks are making “rent-seeking” profits (i.e. those that come from taking advantage of informational or other anti-competitive advantages) in this market, but that the structure makes it not unlikely that rent-seeking profits are being earned.
re: value of CDS pricing to stock market traders
The point is not that stock traders should buy and sell CDS, but that information on CDS prices is material information for stock market traders. Thus allowing people with non-public information on CDS prices to trade on the stock market constitutes legalized insider trading.
From the economists point of view it means that there is sufficient competition (or little enough cooperation/leader-follower behavior across market players) that no profits are made over and above what would be made if there were a competitive market.
‘Cooperation’ doesn’t scan as an apt description of anything here. Leader-follower, at times, but only in the sense of lemmings. 🙂
Looking at your definition, I guess a problem is that I don’t quite see ‘competitive’ as an either/or proposition, but a continuum. Sure, fewer market actors trade CDS than (say) IBM stock, so indeed almost automatically it’s less liquid/more lumpy/less competitive. But it’s still competitive in the generic sense: people can (and do) shop around for the best bid/offer.
Perhaps it’s true to some extent that banks can ‘extract rents’ out of trading CDS – i.e., out of being well-capitalized/staffed/etc/stupid? enough to do so. Similarly, banks can be said to extract rents out of having easy funding access & making loans, out of being FDIC insured and taking deposits, etc etc.
In this case (CDS) if we don’t like those rents, ok, but the remedies that suggest themselves to me all involve lowering barriers to entry. Let 1000s of actors make CDS markets and you will see bid/offers shrink. Yet this doesn’t seem like the direction anyone who makes these complaints actually agitates for, because at the same time there are all these concerns about systematic risk, central clearing, etc. And, why do ‘rents’ bother us exactly? even if banks extract rents trading CDS who is forced to buy/sell them? if rents are so high and damaging why are clients shooting themselves in the foot by entering these contracts?
The point is not that stock traders should buy and sell CDS, but that information on CDS prices is material information for stock market traders.
In practice it’s more nearly the opposite: a CDS trader will basically just monitor the company’s stock price, and will be pretty reactive to it. This only makes sense given that the stock is more liquid so you’d think information gets there first, even if perhaps it should be the other way around in some sort of theoretical/Merton sense.
Anyway, I don’t think CDS spreads (meaning spreads in the sense of prices, here) are quite ‘non-public’ per se. I just think they are not necessarily easy to get one’s hands on (i.e. you may have to pay for some data service).
But my point wasn’t about stock traders anyway. It was about everyone/the layperson. Why does a layperson need to know the bid/offer spread of 3Y protection on MBIA, Inc. What would they do with that info. How would their knowing that info solve the alleged problem (=bid/offer spreads being too high) in the first place – given that laypeople can’t trade CDS and given that that’s the way we want it (I think?).
Essentially, unless it’s just ‘banks are evil’, I don’t quite see what the problem here is supposed to be, and I don’t know what the proposed remedies are meant to solve. Maybe I’m just dense.
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The question is less whether people can shop around for the best bid/offer than whether there are coordination mechanisms of any sort that limit the price improvements that are offered on the market.
why do ‘rents’ bother us exactly? even if banks extract rents trading CDS who is forced to buy/sell them? if rents are so high and damaging why are clients shooting themselves in the foot by entering these contracts?
This is precisely the misuse of economic analysis that I object to in my post. If there are serious distortions in pricing on the CDS market, then the self-interested behavior of your clients is likely to be part of serious misallocation of resources from a social point of view. So my problem isn’t with your clients making or losing money, but with the possibility that the structure of the CDS market can create problems for the economy as a whole.
Arguably the 2008 crisis was as severe as it was in no small part because of the gross underpricing of risk on the CDS market in 2005 – 2007 (though I recognize that CDS aren’t the only markets that failed in pricing risk). The question then is how to restructure the market so that this never happens again.
I don’t think CDS spreads (meaning spreads in the sense of prices, here) are quite ‘non-public’ per se. I just think they are not necessarily easy to get one’s hands on (i.e. you may have to pay for some data service).
I know that the SEC disagrees with me, but I count expensive data services as providing access to non-public information. From the economic point of view, such data fees are inherently distortionary and inefficient, because they create a barrier to people getting the information they need to make informed decisions.
As I argue in my post, I think almost all prices on financial markets should be public information. On the same note, if there’s a layperson who thinks that CDS prices can help him with some decision that he’s making, I don’t see how any value is created by depriving that layperson of this information.
The main value of prices in my view is not to use them for trading, but to use them to understand how the economy operates — but I guess that’s just proof that I’m no trader. Even if it’s illegal or impossible for someone to trade an assets, that person should still have access to the pricing on the asset — on the principle that prices should be transparent.
Essentially, unless it’s just ‘banks are evil’, I don’t quite see what the problem here is supposed to be
No the banks aren’t evil, but they’ve been making the kind of trading profits on financial markets (distributed mostly to employees) that are a strong indicator of markets where competitive forces are failing to function. The question is how to we restructure those markets so that the banks make less money on them.
If my desire to reduce the profits that are flowing to the banks makes you feel like I am vilifying banks, that’s unfortunate, because I don’t see the problem as one of evil, but of poorly structured incentives.
Side point really – I still prefer to speak of degrees rather than either/ors. e.g. It’s not a question of price improvements either being ‘limited’ or ‘not limited’ (they’re always limited by something to some extent no?), it’s only ever a question of degree. So I can grant that b/o spreads are larger in a market like CDS than in one like equities, I just don’t know what conclusion that’s supposed to lead to.
From a larger point of view – the criticism being built here doesn’t stack up as coherent to me.
1) We started with an NYT article complaining/implying primarily that dealers take too large ‘fees’, by which they seem to mean b/o spreads.
2) b/o spreads being ‘too large’ (if that’s the case) means that when banks buy CDS, they don’t pay enough, and when they sell CDS, they charge too much.
3) Now you’re saying that this distortion misallocates resources and underprices risk. Yet, how? Underpricing risk would seem to mean not charging enough to sell protection (as opposed to, charging too much).
Underpricing of risk, however much of a real problem that is, was not an issue raised in the NYT article. But ok, you can raise it here. However now we’re far afield of the complaint about fees. It’s difficult for me to envision how banks taking out lots of fees trading CDS can be the cause of underpricing of risk (at any systematic level; obviously if a bank didn’t pay some client enough for protection, because the b/o spread was too wide, then that client in particular underpriced risk – but that – banks not paying enough to buy protection from anyone – is not a systematic ‘distortion’ one can plausibly worry about, because it’s self-limiting, i.e. if they do it too much, they’ll just have no takers – where’s the distortion?)
From what I know, underpricing of risk (and distortion generally) generally happened in other ways for different reasons, e.g.
-the CDO regulatory-arb business of creating tranches that were priced to a model/rating and sold off, then actively model-hedged (with CDS).
-the AIG (and related – could also count insurers like Ambac, MBIA, and CDPCs as well) style business of writing protection you ultimately weren’t good for.
In both those cases, for different but related reasons, you had actors essentially selling protection too cheaply – not demanding enough in return – i.e., underpricing risk. But this has nothing to do with banks’ b/o spreads being too wide or banks rent-seeking/colluding/the market not working per se. The sickness here was ‘dumb money’ playing in the market, and that dumb money had reasons for existing, and I could go into those reasons (which had everything to do with dumb regulations), but will spare you. Bottom line is surely your economics is better than mine but as you apply it to this story it doesn’t add up to something I quite recognize.
as for public prices:
if there’s a layperson who thinks that CDS prices can help him with some decision that he’s making, I don’t see how any value is created by depriving that layperson of this information.
This seems all backwards. No one is ‘depriving the layperson of information’. It’s just that no one is bending over backwards to go and publish it somewhere that is freely-accessible. Am I ‘depriving people of information’ if I don’t voluntarily post my age, weight, etc etc on the internet somewhere. In a manner of speaking yes, but that’s a weird way to put it. Who merits this information and why? What bad things are caused by them not having this information? are the questions that need to be answered, seems to me.
Look, I’m not even opposed to publicized spreads or anything. I guess there are already a zillion costly things banks are forced to do by regulations, what’s one more. I do wonder why is the null hypothesis that banks should actively publicize pricing data and someone asking ‘why?’ is required to prove that it would ‘create value’ if they don’t? Backwards. But the real issue is still just what would anyone do with this data if they had it. If you have something clever in mind that you’d be doing with it, do let me know what it is, cuz I’m drawing a blank! 🙂
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I read the NYT article differently: in my view it was about a non-transparent market that is being organized by people who may not be focussed on protecting the public interest — the wide spread issue was just an illustration of one potential problem with this structure.
While there were many contributing causes to the crisis, an important factor in my view was the fact that the CDS shorting MBS were not consolidated into a single market and a single price. If every CDS trading a specific MBS or MBS tranche had to be reported (including the price and including those packaged in CDOs), I think that adjustment in the market would have been much faster. That is the 18 month delay in the adjustment of the ABX index to reflect reality had an extremely noxious effect on the financial system. If the ABX had reached in April 2006 the point that it did in September 2007, the crisis would have been smaller.
Effectively the lack of transparency in the market slowed the price adjustment process and resulted in a massive misallocation of assets. In other words, that dumb money was a consequence, not a cause, of faulty price indicators.
I don’t think we’re going to agree on public prices, because I think of prices as the signals that drive economic activity. None of us can imagine what creative products and solutions others will come up with given good quality economic signals. Thus, from my point of view there is a presumption that prices should be public — and I do think that there needs to be a good explanation for a failure to make prices public.
I disagree that broadcast price info of CDS spreads on MBS (frankly I’d thought CDS on MBS were too unique/one-off to have been useful market data to anyone anyway) would have sped up any market adjustment. Dumb CDO money was what kept those spreads down; it’s not clear what learning/knowing those artificially low spreads more publicly/earlier would have accomplished. (It wasn’t any big secret anyway to anyone who looked at that market, but that’s just my recollection.)
Such a thing may have even prolonged the bubble by leading to further complacency: ‘Hmm, I have my doubts about the mortgage market, but look at these CDS spreads! They still imply only 0.5% CDR! I guess they know better than me, I’m wrong, and I shouldn’t short ABX after all.’
re: explanation for not making prices public, ‘the agreed price and terms of this private contract I’ve just signed with so-and-so is none of anyone else’s dang business’ seems like a perfectly good blanket explanation to me. As a fallback, ‘it will cost us pointless money, time and manpower to have to set up ongoing processes making those prices public, those things are limited, it won’t bring in new business (which has everything to do with the diff between CDS and equities), and so we don’t wanna’ also works perfectly well for me.
P.S. btw you’re a good sport to put up with me 🙂
The “dumb CDO” money explanation of the crisis is I think logically flawed in a world with synthetic assets, but the explanation is complicated. I’ll plan to put a post up on this issue over the holidays.
Looking forward to it.
To clarify,’dumb CDO money’ isn’t my explanation for the crisis. It’s just (a major part of) my explanation for artificially-wide CDS spreads, which was the particular point under discussion.
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