Wednesday, February 25, 2009

Repeat ad nauseum: derivatives are nil sum…derivatives are nil sum ……

AIG Update

Let me be perfectly clear - I don't care who wants to trade with whom, provided that I as a taxpayer am not called to bail them out when they fail to supervise their positions. Since it is now clear that none of these firms will (or can) perform their own supervision of these positions there is only one answer that will work to prevent this sort of systemic damage: The trading of CDS contracts off a regulated exchange sans a central counterparty must be banned.

Posted by gardeniadotnet @ 12:46 AM (1766 views)
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39 thoughts on “Repeat ad nauseum: derivatives are nil sum…derivatives are nil sum ……

  • “Superintendent David Hartshorn, who heads the Metropolitan police’s public order branch, told the Guardian that middle-class individuals who would never have considered joining demonstrations may now seek to vent their anger through protests this year.

    He said that banks, particularly those that still pay large bonuses despite receiving billions in taxpayer money, had become “viable targets”. So too had the headquarters of multinational companies and other financial institutions in the City which are being blamed for the financial crisis.

    Hartshorn, who receives regular intelligence briefings on potential causes of civil unrest, said the mood at some demonstrations had changed recently, with activists increasingly “intent on coming on to the streets to create public disorder”. ”
    SD

    http://www.bbsradio.com/cgi-bin/webbbs/webbbs_config.pl?read=25996

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  • garden: let me repeat ad nauseum: most derivatives ARE nil sum. ARE nil sum. ARE nil sum.

    OPTIONS and FUTURES are nil sum!

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  • rotten tomato says:

    If they are so “nil sum”, then why are the financiers colluding with governments to make us taxpayers foot the bills?

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  • excuse the ignorance guys

    is the ‘nil sum ness’ of these derivatives influenced or affected if one party goes bust (joining this debate late and armed with little knowledge)

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  • rotten tomato:

    Futures and Options are a huge part of the derivatives market and they are categorically nil sum.

    Credit Default Swaps (credit derivatives) are the controversial part of the market that are causing the confusion. However even CDS derivatives are nil sum if the counterparties pay up. Most of the counterparties are paying up ,but the ones that are not, are causing serious problems.

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  • last_days_of_disco says:

    This is truly shocking. Do these blighters honestly believe that tax payer are that stupid. Its wrong for them to take out insurance contracts with AIG which then get paid out by the tax payer. Its criminal. The thing that amazes me is that Brown and Blair in the bad old days were real lefties, right down to thinking Stalin was a good guy once you got to know him. Now they are doing *nothing* while the banks are utterly screwing everyone. What a bunch of good for nothings.

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  • tudorian:

    The derivatives market has always been used for speculating (gambling) or hedging (insurance). The vast majority of it has always been traded through open outcry or computerised exchanges like GLOBEX. It is visible, easy to monitor and NIL SUM.

    The CDO/CDS credit derivatives are an abomination that hijacked the name ‘derivatives’. They have been used as a hedge (insurance) and a speculation (gamble) at the same time. This is obviously impossible so therein lies the problem. This problem is compounded by the fact that they are not traded in an open market like real derivatives so it is nigh on impossible to monitor them.

    You could look at CDO/CDS as a derivative where the counter parties do not pay up front. This is where the problem arises. If someone doesn’t pay up on their obligation, then they are no longer nil sum.

    I’ve never liked these products because the real derivatives market already had products that could provide the type of insurance that they purported to offer.

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  • Sorry bob1, how can an option or a futures contract be nil sum if there is counterparty failure. If I hold an “in the money” OTC option on my books and I cannot exercise it because the counterparty goes bust how can I realise my profits? Sorry, but derivatives are only nil sum if the “losing party” can pay up. Same with an uncovered short positions. This is obvious to any mong who has layed a spread bet. The only thing that keeps these things zero sum is an exchange held margin. This obviously reduces the risk of serious levels of default, but that is different from something being zero sum. Moreover, the majority of derivatives are OTC, and one of the issues that has been raised is the lack of daily settlement of many of these contracts. Most OTC derivatives are interest rate swaps and similar. What happens to the predicted cashflows when one counterparty goes bust?

    To say that most derivatives are zero sum (except in a technical, best of all worlds sense where no counter party ever goes bust) is completely and utterly absurd.

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  • Sorry bob1, how can an option or a futures contract be nil sum if there is counterparty failure. If I hold an “in the money” OTC option on my books and I cannot exercise it because the counterparty goes bust how can I realise my profits? Sorry, but derivatives are only nil sum if the “losing party” can pay up. Same with an uncovered short positions. This is obvious to any mong who has layed a spread bet. The only thing that keeps these things zero sum is an exchange held margin. This obviously reduces the risk of serious levels of default, but that is different from something being zero sum. Moreover, the majority of derivatives are OTC, and one of the issues that has been raised is the lack of daily settlement of many of these contracts. Most OTC derivatives are interest rate swaps and similar. What happens to the predicted cashflows when one counterparty goes bust?

    To say that most derivatives are zero sum (except in a technical, best of all worlds sense where no counter party ever goes bust) is completely and utterly absurd.

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  • Doesn’t “nil sum” miss the point? It’s not that it’s incorrect, but that the liabilities are not evenly distributed. The size of the sums involved are huge (probably 100s to 1000s of $trillions, depending on who you read) and owing to the opacity of the system, no-one knows where most of the malign lumps reside.

    This is what has contributed to slowing the velocity of money to almost nil and uncoupled it from its historic relationship to GDP and money supply, and it’s why there’s no confidence.

    In these circumstances, IMHO complete transparency is vital before one more tax penny is moronically lobbed to the assembly of eager bankers.

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  • D’oh

    “This is obvious to any mong who has layed a spread bet”.

    D’oh, I admit to never having laid a spread bet but I have been a professional deivatives and forex trader for more than 20 years.

    Do you undertand how an open outcry or computerised exchange works? Do you undrstand the mechanics of a futures trade? Let me give you an example.

    S&P 500 E mini Futures contract: I press the ‘buy’ button on my trading desk. GLOBEX (a computerised exchange) matches me to another trader who has pushed the ‘sell’ button on his trading desk. The cost of my bet and the other traders bet is immediately and automatically taken out of my brokerage account. When the trade is closed out the losers’ bet is immediately and automatically paid into the winners account. There is no “counter party” risk because both parties bets were placed up front and held by the broker/exchange. This is how futures work. They are nil sum. No one but the traders has to put his hand in his pocket.

    In my earlier posts @5 and @8, I explained the difference between futures/options and credit swaps. Please read them carefully before you start using the words mong and absurd.

    d’oh “Moreover, the majority of derivatives are OTC”

    No they are not. There were almost 3 billion futures contracts and 4 billion options contracts traded last year. They are not OTC but they are Nil sum (incidentally traders call it Zero sum)

    D’oh I understand that you are outraged by the economic crisis but you must realise that reading a few articles and placing a couple of spread bets does not make you an authority on derivatives and the economy. I have a degree in economics and have worked professionally in this business for half a lifetime. I still do not consider myself an expert but I know a thing or two about it.

    By the way, if you worked on a trading floor and got your facts so mangled, you would permanently lose all credibility. If you called someone a mong, you’d better be good with your fists.

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  • D’oh

    “This is obvious to any mong who has layed a spread bet”.

    D’oh, I admit to never having laid a spread bet but I have been a professional deivatives and forex trader for more than 20 years.

    Do you undertand how an open outcry or computerised exchange works? Do you undrstand the mechanics of a futures trade? Let me give you an example.

    S&P 500 E mini futures contract: I press the ‘buy’ button on my trading desk. GLOBEX (a computerised exchange) matches me to another trader who has pushed the ‘sell’ button on his trading desk. The cost of my bet and the other traders bet is immediately and automatically taken out of my brokerage account. When the trade is closed out the losers bet is immediately and automatically paid into the winners account. There is no “counter party” risk because both parties bets were placed up front and held by the broker/exchange. This is how futures work. They are nil sum

    In my earlier posts @5 and @8, I explained the difference between futures/options and credit swaps. Please read them carefully before you start using the words mong and absurd.

    “Moreover, the majority of derivatives are OTC”

    No they are not. There were almost 3 billion futures contracts and 4 billion options contracts traded last year. They are not OTC but they are nil sum.

    D’oh I understand that you are outraged by the economic crisis but you must realise that reading a few articles and placing a couple of spread bets does not make you an authority on derivatives and the economy. I have a degree in economics and have worked professionally in this business for half a lifetime. I still do not consider myself an expert but I know a thing or two about it.

    By the way, if you worked on a trading floor and got your facts so mangled, you would permanently lose all credibility. If you called someone a mong, you’d better be good with your fists.

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  • d’oh

    The word mong is slang for a child with Down Syndrome. Don’t use it again

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  • bob1:
    (1) My last job was architecting a central counterparty exchange platform. I have been an invited plenary speaker on finance at a conference held at the SWX and have been an invited speaker at a number of academic economic conferences (though I am not an ecnomist). I might just happen to know something too.

    (2) As I pointed out, exchange traded contracts are not a problem because of margin requirements being constantly monitored by a third party. These are not the issue. They are zero sum (more or less). I stated as much above. Counter party failure is covered here (more or less, though one can imagine catastrophic situations when the margin monitoring could breakdown).

    (3) There is a lot of churn in ETDs. I agree. Just look at any market maker who will trader stupid volumes of these things every day, but will have closed all positions by the end of the day. This is not a problem, though theoretically could be if there was a major saltation in a price due to an unexpected major event. However,

    (4) This doesn’t apply to OTC derivatives. What is important is the amount outstanding. There are a huge amount of OTC derivatives outstanding, I suspect much, much more than the amount of ETD derivatives outstanding at anyone given point in time. (I don’t quite see how the BIS figures are comparable across different types of derivatives, but the ETD derivatives have an annual notional turnover approximately one half of the OTC derivatives notional amount outstanding.) However, the notional amounts are huge which must indicate something about the risk, though what the real risk is is clearly not known. Unless one knows how the accountants have handled these things, one doesn’t know the effect on the books of one party if the other party fails.

    The spread bet example was just to make the point clear. Igindex, for instance, makes losses from being unable to recover money from some counterparties even though they have margin requirements etc. Now, this may not happen on “real exchanges” but you can be darn certain that it is a real risk with OTC products.

    Generalising what happens with exchange traded derivatives to the OTC market, which is acknowledged by every authority I have ever read to be larger, is, as I asserted above, absurd. There may be very little counterparty risk in an exchange where you trade, but there is certainly counterparty risk in OTC products. A contract cannot just be cancelled if one side cannot pay without affecting the books of the other. A counterparty failure leads to a contract not being zero sum. Simple as. Exchange margin requirements exist to limit that risk. We do not know what the situation is with OTC derivatives. (Okay, many of these OTC contracts will have had insurance components, but if the insurers cannot pay then the insurance can be disregarded.)

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  • bob1:
    (1) My last job was architecting a central counterparty exchange platform. I have been an invited plenary speaker on finance at a conference held at the SWX and have been an invited speaker at a number of academic economic conferences (though I am not an ecnomist). I might just happen to know something too.

    (2) As I pointed out, exchange traded contracts are not a problem because of margin requirements being constantly monitored by a third party. These are not the issue. They are zero sum (more or less). I stated as much above. Counter party failure is covered here (more or less, though one can imagine catastrophic situations when the margin monitoring could breakdown).

    (3) There is a lot of churn in ETDs. I agree. Just look at any market maker who will trader stupid volumes of these things every day, but will have closed all positions by the end of the day. This is not a problem, though theoretically could be if there was a major saltation in a price due to an unexpected major event. However,

    (4) This doesn’t apply to OTC derivatives. What is important is the amount outstanding. There are a huge amount of OTC derivatives outstanding, I suspect much, much more than the amount of ETD derivatives outstanding at anyone given point in time. (I don’t quite see how the BIS figures are comparable across different types of derivatives, but the ETD derivatives have an annual notional turnover approximately one half of the OTC derivatives notional amount outstanding.) However, the notional amounts are huge which must indicate something about the risk, though what the real risk is is clearly not known. Unless one knows how the accountants have handled these things, one doesn’t know the effect on the books of one party if the other party fails.

    The spread bet example was just to make the point clear. Igindex, for instance, makes losses from being unable to recover money from some counterparties even though they have margin requirements etc. Now, this may not happen on “real exchanges” but you can be darn certain that it is a real risk with OTC products.

    Generalising what happens with exchange traded derivatives to the OTC market, which is acknowledged by every authority I have ever read to be larger, is, as I asserted above, absurd. There may be very little counterparty risk in an exchange where you trade, but there is certainly counterparty risk in OTC products. A contract cannot just be cancelled if one side cannot pay without affecting the books of the other. A counterparty failure leads to a contract not being zero sum. Simple as. Exchange margin requirements exist to limit that risk. We do not know what the situation is with OTC derivatives. (Okay, many of these OTC contracts will have had insurance components, but if the insurers cannot pay then the insurance can be disregarded.)

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  • Dismissing the logical thrust of an argument due to the etymology of a throw away term, and ignoring the caveats in the original argument are really lame tactics.

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  • I have to agree with d’oh. If I were to have written billions of dollars of CDS on, say Lehman Bros, and I didn’t have the cash to pay up when they went bust, the people who were counting on me paying would be stiffed. Ergo its not zero sum if someone in the chain doesn’t pay. There will be a net loss overall. If bob1 has worked all his life in financial markets and hasn’t worked that out, well, it kinda explains why we are in such a deep hole right now……

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  • ps for bob1: The exchange I and my team built trades derivatives. (In fact it can match batches of derivatives where there are no direct counterparties…it’s very nice…we can even take a risk position as the exchange if we wanted to.) It’s actually quite funny that you try and batter me with the argument “do I know how a computerised exchange works?” I can truthfully answer that with: “intimately”.

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  • Finally, for the BIS’s opinion on the robustness of clearing houses see:

    http://www.bis.org/publ/cpss23a.pdf

    The seemed to think there are all sorts of counterparty/clearing house/settlement risks. Admittedly, this paper was published by the BIS in 1997, but I doubt much has changed in terms of the types of risk they identified. See p29 onwards for the authors’ summary of risks.

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  • Finally, for the BIS’s opinion on the robustness of clearing houses see:

    http://www.bis.org/publ/cpss23a.pdf

    The seemed to think there are all sorts of counterparty/clearing house/settlement risks. Admittedly, this paper was published by the BIS in 1997, but I doubt much has changed in terms of the types of risk they identified. See p29 onwards for the authors’ summary of risks.

    Apologies for the double posts today, my browser has stopped putting in my Admin password, and I’m just used to posting without checking that it is there.

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  • d’oh

    I’m glad I’ve stung you into talking some sense. All I have done in my posts is make the distinction between the OTC market and the regular derivatives market. I also pointed out that most of the regular derivatives market is zero sum whereas the OTC is not always zero sum. Now you have done the same. If you knew this to be the case, why did you jump in with all that boorish contradictory stuff @8?

    I have always disapproved of the OTC market because so much of it is not zero sum and causes systemic risk. However, the press has encouraged the view that the swap market IS the derivatives market and many HPCers have taken a lead from this press misinformation. All I have tried to do in my posts is explain that the swap market is just a part of the derivatives market. Nothing more nothing less.

    D’oh you said “the OTC market, which is acknowledged by every authority I have ever read to be larger”

    This is not true. Here’s a rough breakdown of the derivatives market size (1 year ago)

    Credit derivatives (much of it is CDOs): $62 trillion
    Equity derivatives: $114.1 trillion
    Futures and the options: $49 trillion

    Do you see why it is important to distinguish the OTC (not all zero sum) from the rest of the derivatives market (mostly zero sum)?

    Anyway I’ve no desire to fall out with you. As you are someone who works at the periphery of the industry, I would appreciate the opportunity to tap your brain at a later date

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  • Game, set and match to d’oh, I think!

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  • d’oh

    “”In fact it can match batches of derivatives where there are no direct counterparties”

    Very interesting. Can you explain a bit? I think the DTCC is working on this as well.

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  • gower: d’oh didn’t read my posts properly and jumped in with some factually incorrect data and descriptions. He has had the good grace to improve his position. Why don’t you learn from this?

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  • Bob1 and d’oh.

    As you are two of the more knowledgable posters on this forum, it’s a shame to see you entering into a slanging match. Neither of you are really doing yourselves justice.

    Bob1, I usually read your commets with interest, but in #7 you’ve not met your usual standards. Aside from the fact that they are both credit derivatives, CDOs and CDS have nothing in common.

    CDS are used, as you say, either as a hedge or for speculation, but in this they are the same as most other swaps, options and futures. The main problem with them is that a huge quantity have been sold, probably far too cheaply, and the opacity of the market has led to doubts about some of the larger writers ability to meet their obligations. As with other swaps, margining is common, so it is likely that the risks are exagerated, and so far the frequently heralded explosions have failed to materialise. (The fact that AIG are using their unquantified CDS risk to con the US government out of ever more bailout money is neither here nor there.)

    CDOs on the other hand, are quite different from those relatively simple derivatives, are generally used for investment, (arguably speculative), but not for hedging. In fact, to all intents and purposes, buying a CDO is little different from buying a corporate bond and poses similar risks. However the way that CDOs were constructed and rated was on the verge of fraud, and the buyers of these instruments were negligent in not realising that. So, although I’ve nothing against securitisation in general, I don’t think anyone involved in that market can walk away from this debacle with much credit.

    I suspect you know all this, but for the benefit of less experienced readers I think it’s important to seperate CDOs and CDS.

    d’oh. You obviously know plenty about exchanges, but that’s not the same as understanding derivatives risk. The OTC market is larger in notional terms but the exchange traded market is far larger in terms of premium. There is no point in looking at the derivatives market in terms of notional value, it bears no relationship to the amount of money actually at risk, to either counterparty. For example, I have in front of me a report on one particular set of OTC derivatives, where the notional value is over $1000mm, but the premium (and hence the most we could lose on these particular options) is only just over $3mm. Newspapers love to talk of derivatives in terms of notional value because it sensationalises the issue; we shouldn’t fall into the same trap.

    Also, we post margin with our prime brokers on the vast majority of our OTC derivatives, as well as our exchange traded positions, so counterparty risk is fairly minimal.

    Anyway, I’ll shut up now. Keep up the good work.

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  • ps. yes I realise premium is not indicative of the amount of money at risk in the derivatives market either. Lets just say it’s a lot less than the notional value.

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  • still renting: good for you. I’ll stop arguing with d’oh. He is a useful contributor

    Yes sometimes I try to avoid going into long descriptions at the risk of oversimplifying. I lumped CDO’s with CDS because they are inexorably linked. Bankers created Credit Default Swaps using money from CDO’s as the collateral for the CDS. It is also the case that a CDO backed by CDS is called a synthetic CDO.

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  • I like these sort of discussions because I end up learning something. However I’d like to ask the question – what use are these things in the ‘real’ world? If the derivatives market disappeared tomorrow, would it affect me or anyone else? Not trying to be smart or stir – as pointed out at the start of the post, people are getting very angry about what they see as money-making exercises for City boys – I get the impression that if the public understood how these activities benefit everyone else, they may be less critical. Anyone?

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  • gower; I’ve just read your post @16.

    You have missed the entire point of my post. Are you willfully ignorant or just plain dumb?

    This is probably not simple enough for you but here goes:

    I have written over and over that the OTC market is often not nil sum. I have never wavered from this and yet your imbecilic argument is that I do not understand that it is not nil sum. Come on Forest!!

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  • shipbuilder: This is a timely question. It would take a monster post to cover it but I’ll try to give a few examples.

    1. Farmers need derivatives to ensure that they stay in business in the event of crop wipeouts or market surpluses
    2. Retailers need derivatives to avoid currency fluctuations rendering an imported line uneconomical
    3. Airlines need derivatives to soften the effect of fuel cost spikes.

    Obviously I have over simplified and there are thousands of more complicated examples but there it’s a start

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  • bob1:

    Apologies for getting splenetic…I suppose I get tired of people saying that derivatives (without specifying what they mean by that in particular) are zero sum, when isn’t always true (as in the examples you have given) and only technically true in the case of OTCs under the assumption that all the clearing houses and settlement facilities hold up to their sides of the bargain, which may not be possible if there were serious intraday movements. (Imagine a terrorist nuclear weapon going off in Manhattan and its effects on currency futures…but this sort of thing isn’t really relevant to the discussion and I am happy to conclude that for all intents and purposes ETDs are zero sum.) Rereading your initial posts, I see that what you were saying doesn’t contradict what I was saying. However, this forum has a history and I don’t always read things closely the first time when I think I know what is coming…been following HPC for too long now.

    As to the size of the markets, my understanding was that the notional value of OTCs oustanding was on the order of $600 to $700 trillion, and that the notional annual turnover in ETDs was about half of that figure. (BIS figures. Though note my comment about notional values not being commensurable.) This is the figure that was in my head when I made the statement that the OTC market is larger than the ETD market.

    The matching batches of derivatives: I can’t go into it too much for IP and contractual reasons, but I can give a simple example pertaining to the sports betting market that should be understandable to anyone reading this. Suppose you have a football match (ManU vs Chelsea) and treat the final score as your underlying. If there are two open bids in the market (ManU wins, ManU loses) then there is an implied price for the bid (ManU draws) at which the exchange can match all three orders risk free (e.g. if the first two were priced at 2:1 then, as a central counterparty, you’d be happy to match a batch of orders with a draw priced at anything less than or equal 2:1). Now, this can be generalised to almost any underlying space and more complex derivatives, including multidimensional continuous spaces. What you find is that with only a few orders placed you can get fair prices for infinite numbers of related derivatives. It really improves liquidity, which is a major issue for gambling exchanges in particular.

    Obviously, in a real matching engine things are more complex as you need to manage broken legs, risk positions taken by the exchange (if allowed), deal with margins and fees and other rules etc. all in real time for high dimensional spaces. There are also other issues relating to keeping the order books in consistent states when orders are being pulled and added at rates much faster than the time it takes to match the tops of the books. It can be done, but that is where the IP and cleverness comes. I’ve seen a few arbitrage engines for these sorts of problems and none of the others I have seen have hit on the “correct” way to do it. It makes me wonder just how clever a lot of these quants are.

    The book keeping and feeding out of prices, logging orders, checking margin requirements etc., is all pretty standard stuff.

    We started out quite a few years ago building this platform with financial exchanges in mind and there were serious talks with UK and European exchanges, but over the past few years we focussed on betting exchanges, as they are less conservative and more willing to take a risk with a new idea that solves one of their major problems. I left at the end of last year for a number of reasons, and it is quite possible that the company which owns the platform will go under, due to contractual mismanagement and the concomittant lack of a few million quid in finance. It will be a great shame if that happens (especially for the value of my share options) as the idea behind the platform is first class and I put a lot of work into it over 5 years.

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  • do’h

    Thanks for that. You are a gentleman. I was getting a bit confused because the argument was getting heated while we were in fact agreeing on most things.

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  • As to the effect of the current crisis on the funding of small companies – we had some investors in in early September 2008, stating that there was no problem with getting a few million and that the various people involved were all in good financial health. They were very keen. What surprised me at the time was that that they didn’t see what was coming…but of course one keeps your trap shut in those sorts of discussions. Within a month (Lehman going down and early October), the money had all dried up as the investors were firefighting for their “fortunes”. Always surprised that people remained as exposed as they did, when they had a year’s warning.

    Still renting – 0.3% of 600 trillion is still a big number…but I agree that the notional values of the OTC and ETDs really aren’t commensurable. On the other hand, the upfront losses due to a counterparty failure also probably underestimate their effect in terms of GDP. Consider all the local authorities in Australia that have been sold MBSs or the UK authorities that invested in the Icelandic banks… they aren’t bankrupted by the ultimate counterparty to the derivative (i.e. home “owners”) defaulting, but their finances will be badly hit, council workers lose their jobs or local taxes are raised, and the velocity of money drops off a cliff.

    Clearly, credit derivatives have caused carnage…allowing land prices to get out of hand, allowing all sorts of debt laden destructive takeovers to happen, forced unnatural growth rates for companies in fear of being taken over etc…arguing about whether what is at risk is 1 trillion or 10 trillion doesn’t seem to be that important when it is quite clear from what has happened over the past 2 years that it is too much.

    The other thing is that notional value, if it pertains to some underlying, must indicate something. World GDP is 40 trillion if I recall correctly, so a notional of 600 trillion must indicate that significant gambling is going on (as opposed to insurance/hedging), as surely the total value of all possible underlyings can’t be more than 600 trillion? Insurance and hedging surely increases market efficiency and hence in that sense derivatives are a “good thing”, but speculation beyond the underlying value of the things being speculated on must surely do the opposite…creating market inefficiencies/parasitic cashflows out of production etc. Or am I misunderstanding?

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  • d’oh. I think that still renting is saying that the total notional value is not the same as the total ‘at risk’. Obviously leverage and overtrading causes the notional value to be several multiples of GDP but the actual risk is significantly less (still a ludicrous amount though)

    I’ve got a 100 lot trade on now. The notional value of the trade is $5 milion but my maximum risk is a fraction of that. In this simple trade the risk is limited by a stop loss or a margin call, however I do appreciate that it is not always as simple as my example

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  • still renting says:

    d’oh

    The trouble with notional value, is that it has different implications for different types of derivatives. For a CDS, the notional would be the maximum amount the seller would have to pay out in event of a default, (I think). For an interest rate swap, on the other hand, it’s the theoretical principal on which the interest is being swapped, so in a low interest rate environment the notional value might be, say, 50 times greater than the cashflows being swapped. So notional value is useful for looking at risk in similar derivatives, but not for understanding the total derivatives market. (Please correct me if I’m getting this wrong, I’m not an expert, and doubtless less experienced in the industry than you or Bob1.)

    On the wider issue of speculation using derivatives, I’m not sure it is necessarily harmful. Like gambling, someone wins and someone loses, but the net result is usually zero. I can’t see why speculation would cause market inefficiencies, though it may well increase market volatility. Of course, speculative bubbles are harmful, but they can and do occur with or without derivatives. Tulip bulbs, anyone?

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  • still renting says:

    Or what Bob said, rather more concisely than I did. I really should refresh the page before I comment. :o)

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  • still renting @ 33 – I think you and bob missed my point about notional value, but you more or less made the point I was trying to make in your response @ 33. It is very clear that notional value of the underlying asset that is effectively controlled by a derivative is not equivalent to the maximum risk. e.g. bob’s example…If I held a 100 pound a point long futures FX contract for GBP/USD at 1.42, then I’m controlling, approximately, 1.42 million pounds, but if I have a stop at 1.41, then my maximum risk is only £10,000 (ignoring slippage). So the amount at risk is only 0.6% of the notional value of the contract. That is fine. The notional value and the amount being risked are very different.

    What I was saying though is that the notional value of the contract points to control/insurance/hedging of an underlying asset of a particular value, in this case £1.42 million pounds. Now, I’ve seen estimates that the value of all financial assets is circa $150 trillion (that was in 2005, so is probably less now)…add in land and private businesses etc, and say everything is worth $400 trillion. If there are $600 trillion of outstanding OTC derivatives, then that means that everything is covered 1.5 times by an OTC derivative. If you want to insure something, it only needs to be covered once, so the factor 1.5 suggests quite strongly that OTC derivatives are not just being used for insurance, but are a form of gambling.

    Why is this important? For exactly the reason you suggest. The point of insurance is that it smooths out returns etc., providing a stable background for business – the usual reason given in “Derivative 101” for the existence of derivatives/futures contracts. If changes in asset values are being magnified through gambling, then you are boosting variance in prices etc. which makes the business environment less stable. Have I explained that? This is why I think the notional value of OTCs cannot be ignored…not because it tells us anything about the amount at risk, but because it indicates that we have a lot of people gambling on the side and this is economically inefficient because it exaggerates swings.

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  • hello d’oh

    Sorry I have to economical with my replies because I’m trading Chicago (and I’m a lazy bastar*)

    An ‘overhang’ of derivatives has always been virtually encouraged because liquidity is so important to their proper functioning. The problem is that there is far too much overhang at the moment.

    The only reason I posted was to explain to HPCers that there were some derivative types that were largely zero sum and some derivative types that were often not zero sum. That is really my only point

    I think that still renting was just pointing out that the ‘at risk’ value of OTC derivatives is less than their notional value. He made this point because notional value was being used to overstate the size and risk of the OTC market

    Regarding your point re notional value: I’m sure everyone agrees with your point about notional value being significant – mostly because of the sheer volume of this crap. Incidentally, the recent ‘mark to no market’ nonsense has been a deliberate ploy to hide the real notional value of these derivatives. If you ignore the ‘mark to no market’ jiggery pokery, then the true notional value is almost one quadrillion dollars! Obviously this is too much. Sadly in todays market too much of this notional value is becoming real value because counter parties to the OTC derivative are going bust at an alarming rate.

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  • twaddle ~~~~ you’re all getting bogged down in pointless detail.

    Just like a sperm and an egg give birth to a complex human being, when they create the debt based money supply they do not create the interest. Just because the origin is incredibly simple it doesn’t follow that the outcome can be decoded by looking at the results.

    Go back to the source, look to your roots. Please! Gentlemen! let’s have some order.

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