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Ted Butler''s silver report: Signs of supply tightness on first delivery day
Derivatives markets outstrip regulation;
Favorite tool of hedge funds
is now a $140 trillion industry
By Tom Bemis
Commentary Editor
CBS.MarketWatch.com
Tuesday, June 29, 2004
http://www.marketwatch.com/news/yhoo/story.asp?
source=blq/yhoo&siteid=yhoo&dist=yhoo&guid=%7B12E497F6%2DBEB9%2D4DEF%
2D8697%2D8629275E932C%7D
Like an unruly, rambunctious, and fast-growing
teenager, the global market in over-the-counter
derivatives is starting to give its parents some
really big headaches to worry about.
These poorly understood financial instruments
have been at the center of most of the financial
debacles of the past decade -- Barings, Orange
County, Long Term Capital, and, of course,
Enron.
They've been called financial "weapons of mass
destruction" by no less an investment sage than
Warren Buffett.
Moreover, a huge portion of these financial
transactions exists in a netherworld of little or no
regulation, making them the polar opposite of what
is meant by open and transparent markets.
Yet their use grows by an estimated 30 percent
a year from already stunning levels.
"There's a reckless way to regulate them and
there's a good way to regulate them. And right
now we're definitely on the reckless side," said
Randall Dodd, executive director of the Financial
Policy Forum, a think tank in Washington.
What troubles Dodd, among others, is the
possibility that one of the major banks or
broker-dealers at the heart of the derivatives trade
could run into a problem that cascades into a
full-fledged global financial crisis.
"Those dealers are central to the market and
they're also a central part of our financial system,"
Dodd said. "So if some big bank like Citigroup or
Bank of America fails, then the whole payments
and settlements system in the economy is
arrested."
Central bankers take the matter seriously, given
the potent mix of conditions: Derivative
instruments have no reporting requirements, and
global hedge funds make abundant use of them.
On Monday, Bank of England officials warned that
hedge funds pose a threat to financial stability as
they continue to seek higher yields with enormous
amounts of money in play.
Options contracts are the most familiar type of
derivative because their use is so widespread. In a
classic example, an option can be used to hedge
against the decline in value of an asset can't be
sold at the moment -- soybeans or corn growing
in a field, for example.
As interest rates remained low and debt
underwriting jumped, brokerage firms made
millions of dollars selling specialized derivative
products to protect debt issuers from things like
swings in interest rates or fluctuating currencies.
In a rising rate environment, however, at some
point underwriting volumes will decline, and the
derivatives business may not be as profitable.
While so-called exchange-traded derivatives are
well understood, the over-the-counter market for
derivatives exists without any significant oversight
or regulation.
It's this market that has grown so exponentially
over the past 15 years. When Bill Clinton entered
office, "the over-the-counter derivatives market was
just $3 trillion," Dodd said. "Today it's $140
trillion," he said.
It's hardly surprising. Trading in derivatives has
proved enormously profitable for many of the world's
largest banks and broker dealers.
And it's that very profitability that fuels opposition
to regulation. "The big dealers are all the major banks
in New York, plus the big broker dealers like Morgan
Stanley, Merrill, Goldman Sachs, and that kind of
crowd," Dodd said. "If they went to a more
multilateral exchange type of platform with reporting
standards and transparency, then their income from
this activity would go down substantially."
As Robert Fuller, principal and founder of Capital
Markets Management, pointed out, trading firms
worry that the machine they created could be
dismantled.
"They like doing these things sub-rosa. As markets
become transparent it's very easy for people to come
in and reverse engineer. So they'll resist as long as
they can."
To be sure, there are many responsible uses for
derivative contracts. For one, they make it much
easier for companies to have access to funds
without having to go to the expense of bond
offerings. And they give banks a tool to overcome
the inherent bias toward "being long" in their
business of borrowing short-term deposits and
lending the money out long term.
"Fannie Mae and Freddie Mac couldn't operate if
they couldn't hedge with derivatives," Dodd said.
"They couldn't do what they do. And our home
mortgages would be much more expensive."
Regulations similar to efforts made in the 1930s
to rein in banking and broker dealers could make
the U.S. financial system stronger, if less
profitable for large and influential financial
institutions. "We need to learn from the past
and apply [those lessons] to our derivatives
markets, which have grown up so recently that
they've never come under that type of attention,"
Dodd said.
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