Opinion

Felix Salmon

When pension funds shun OTC derivatives

By Felix Salmon
February 10, 2010

Has Illinois’s Kevin Joyce been reading Andrew Clavell? There’s something quite elegant in its simplicity about this:

Illinois is considering a bill to avoid derivatives abuse by public pension funds, Pensions & Investments reports. The bill, which is under discussion at the Illinois House Rules Committee, will restrict the state’s public pension funds from investments that trade derivatives in non-public markets.

In reality, it’s not the pension funds which are engaging in “derivatives abuse”, but rather the investment bankers who sell the pension funds complex over-the-counter derivatives which make the broker lots of money and which rarely do any good for the end client. As Clavell says,

Let’s assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense…

Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The really elegant part of this bill is that it allows investments in traded derivatives, and therefore gives the sell-side an incentive to find tradable alternatives to their beloved OTC derivatives. If a large chunk of the buy-side adopts this kind of policy, we could achieve by market forces the move to derivatives exchanges which is proving so hard to legislate.

Comments
4 comments so far | RSS Comments RSS

I agree completely – great bill.

Posted by Beer_numbers | Report as abusive
 

Interesting enough, the sponsor of this bill (Joyce) comes from a big trading family… they were/are active on CBOE and CBOT

Posted by br_add | Report as abusive
 

I agree that derivatives dealers are oftentimes as sleazy as used car salesmen, particularly when they were shilling lemons as egregious as, say, CPDOs and CDPCs. And this legislative prescription is simple and sensible, provided it’s limited to the state’s public pension funds. But does it go far enough? It’s a solution only for Illinois public pensioners.

Perhaps what we need is a derivatives market-equivalent of a lemon law. The market for complex derivatives (as with used cars) possess a large potential for asymmetric information, which to me screams for intervention. Libertarians (and, of course, bankers) will cry foul, but I’m beginning to think that’s a signal of good policy.

Now that said, I’m a little taken aback by Clavell’s tone. Bankers like to fancy themselves the only ones who get it–worse actually, the only ones smart enough to possibly get it. I’m no banker, but give me a shot.

Posted by Sandrew | Report as abusive
 

There’s another situation where derivatives can work well. The end user gives the specs, and places the big investment banks in competition against one another to provide it.

I’ve done that for clients. I works well, but you have to be willing to do the intellectual work, rather than sitting back and letting the investment banks trick you with their latest product.

It goes back to my saying, “Buy what you want or need, don’t buy what someone wants to sell you.”

Posted by DavidMerkel | Report as abusive
 

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