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Raising the curtain on the private nature of derivatives
By Aline van Duyn
Published: September 17 2010 19:30 | Last updated: September 17 2010 19:30
The thousands of people working in derivatives are not normal, or at least not when it comes to how they visualise
trading.
I have talked to hundreds of people as part of my job. When the conversations have turned to trading, they have
tended to fall into two categories.
The first is by far the biggest. It includes people who have little detailed knowledge about finance, such as
teachers or doctors or fitness instructors, but also a surprising number of business people who work in nonfinancial divisions of large companies, regulators and even investors.
When the people in this first category think about trading, the mental images that spring to mind are the kinds that
are used in movies like Trading Places and Wall Street. Drama is created by showing moving prices and traders
trading. These are reinforced daily by the steady stream of stock prices that run across financial television
channels, storefronts and iPhones, among others. Trading is “seen” as consisting of constantly updated prices,
moving around the clock, and involving lots of people.
The second group see things rather differently. These are the people who understand the way private, and often
illiquid, markets work and regard them as perfectly normal ways to operate. Deals are struck among experts. They
take time. There are negotiations. Not everyone needs to know who is doing what, or at what price. A savvy trader
or investor can do well, and others can get burnt. That’s what makes a market work.
Yet these differences now matter as private and public markets collided more than ever during this financial crisis.
This has been particularly stark in the derivatives markets, which have grown into one of the biggest sectors of
finance. The face value of private derivatives contracts is estimated to be more than $600,000bn. Yet it is only
now emerging that many of these contracts are rarely, if ever, traded.
According to Conrad Voldstad from the International Swaps and Derivatives Association, there are fewer than
2,000 standardised interest rate swaps traded on an average day. The most active – 10-year dollar swaps – trade
just 200 times a day and most trade 20 times or less, or once every half-hour. In contrast, stocks are traded every
fraction of a second. “They illustrate the story of a market that has much less volume than one might imagine,” Mr
Voldstad said.
It is exactly this that has caused such concern. When companies – or countries such as Greece – are in trouble,
the prices on their credit default swaps can drive sentiment. CDS are regarded as accurate gauges of default risk
– and prices posted on screens or conveyed over the phone are widely cited. At the height of the financial crisis
two years ago, wild swings in some banks’ CDS caused concerns they were about to go under. Yet, one regulator
recently told me, there was one day in 2008 when there were only two trades in CDS that caused worldwide
market panic.
New laws are supposed to bring this market into the open, but shedding light on the derivatives market will not be
without stumbling blocks. One sticking point is how soon trades are reported.
Bill De Leon at Pimco is worried about the “winner’s curse”. If screens quickly display what derivatives are traded,
it can be pretty easy for expert traders to guess who is doing the trade. Relatively few investors are active in
particular types of swaps. The traders will adjust their prices accordingly – effectively using this information against
the investor. There is a lot more data available about the derivatives market than there was two years ago. But
trading volumes in interest rate swaps, for example, are still publicly unavailable.
More information about historic volumes needs to be made public. If derivatives are associated with a figure like
“five trades a day” rather than “$600,000bn”, there might be a better chance for a rational discussion about what
information should stay out of the public eye. Evidence from bankers – and investors – about what is normal for
derivatives is sorely needed.
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