Felix Salmon

The NYT takes on the derivatives cartel

By Felix Salmon
December 13, 2010

Back in September, the Chicago Fed hosted a symposium on OTC derivatives clearing. (Bear with me, don’t fall asleep just yet.) The luncheon keynote was given by Ken Griffin, and summarized by Craig Pirrong, who was there:

Griffin gave a paean to central clearing, and to Dodd-Frank more generally. Clearing is cheaper operationally and administratively. It reduces risk. It economizes on capital. It is the cure for all that ails the financial markets.

So if it is so wonderful, what stands in the way of its adoption? Per Griffin: a small, self-interested cabal of dealers who reap billions and billions of profits at the expense of end users, and who will lose their ill-gotten gains in a cleared world.

This narrative is a familiar one, the stock theme of the advocates of central clearing.

Today, the NYT’s Louise Story took Griffin’s complaint and elevated it to the status of the main front-page story of the Sunday paper. It’s a long and powerful piece, which alleges that a small group of powerful investment banks are doing their utmost to keep the lucrative OTC derivatives business for themselves; the cabal even has a secret meeting, in midtown Manhattan, on the third Wednesday of every month.

I’m sympathetic to Story’s case here, even if it’s hard to have much sympathy for Griffin, a billionaire who clearly wants to export his high-frequency trading techniques from the stock market to the options and futures markets. I think that Story and Griffin are right that we would be better off with much more derivatives trading centrally cleared, and that the biggest derivatives dealers are doing their best to stymie such a move.

But that said, Story’s story is quite one-sided. She doesn’t talk about Griffin’s profit motive, and she’s far too credulous when it comes to other would-be competitors in the derivatives space. Look at this, for instance:

The Bank of New York Mellon’s origins go back to 1784, when it was founded by Alexander Hamilton. Today, it provides administrative services on more than $23 trillion of institutional money.

Recently, the bank has been seeking to enter the inner circle of the derivatives market, but so far, it has been rebuffed.

Bank of New York officials say they have been thwarted by competitors who control important committees at the new clearinghouses, which were set up in the wake of the financial crisis.

Bank of New York Mellon has been trying to become a so-called clearing member since early this year. But three of the four main clearinghouses told the bank that its derivatives operation has too little capital, and thus potentially poses too much risk to the overall market.

The bank dismisses that explanation as absurd. “We are not a nobody,” said Sanjay Kannambadi, chief executive of BNY Mellon Clearing, a subsidiary created to get into the business. “But we don’t qualify. We certainly think that’s kind of crazy.”

It’s pretty obvious that being founded by Alexander Hamilton in 1784 and being “not a nobody” are not sufficient to be admitted to a central clearinghouse. The way those clearinghouses work, the strongest members bear a lot of risk should one of the weaker members fail, and so it’s reasonable for them to want to try to minimize that risk by forcing members to put lots of capital into their derivatives arms — especially would-be members who think such demands are “kind of crazy”.

So a bit of third-party adjudication would have been welcome here: does BNY Mellon really have so much capital that its acceptance into the derivatives-counterparty club is a no-brainer, as Kannambadi would have us believe? We don’t know: Story simply gives him the last word, and moves on.

More generally, there’s no evidence that Story ever talked to Pirrong or any other third party who takes the other side of the argument. And the other side, as presented by Pirrong in response to Story, does make a certain amount of sense:

The Citadel commander’s argument presumes that end users–who, as he properly notes, must be the ultimate source of any dealer market power profits–are the victims of some sort of battered spouse syndrome. For end users are among the most vociferous opponents of clearing mandates. FMC Treasurer Thomas Deas was quite outspoken on this score at the session immediately prior to Griffin’s speech. Why are end users the most ardent defenders of a system that is supposedly rigged against them, and robs them blind? …

Criticisms like Kenneth Griffin’s and Louise Story’s remind me of what Yogi Berra said about Ruggeri’s (a restaurant on The Hill in St. Louis): “Nobody goes there anymore. It’s too crowded.” The OTC markets are big and crowded with customers. If they’re such a bad deal for these customers, why is that true? Why hasn’t entry, or the movement of customers to available substitutes, constrained market power and prevented exploitation of customers? Not to say that such an outcome is inconceivable, just that Louise Story, Kenneth Griffen, and the cast of thousands who criticize OTC derivatives markets haven’t come close to answering these questions.

I long for the day when there will be serious consideration of these issues, rather than superficial black hat-white-hat narratives.

Story took an extremely recondite subject and did a masterful job of explaining it in easy-to-understand terms; what’s more, her heart is clearly in the right place. As such, it feels a bit churlish to accuse her of oversimplifying matters: in an important sense, it’s her job to take complex subjects and simplify them to the point at which they can be generally understood.

But the front page of the Sunday NYT is an extremely powerful bully pulpit, and comes with a lot of responsibility to deliver a balanced and nuanced take on such subjects. Story’s piece is long enough as it is, and maybe couldn’t be extended any further. But I would have loved to have seen a good-faith effort to explain the big banks’ side of the argument, and also to give the banks’ opponents opportunity to respond to those arguments, much as Steve Waldman did online. But maybe that’s what the blogosphere is for, these days.

19 comments so far | RSS Comments RSS

the author’s example of heating oil hedging is a peculiar one… not only are real time data available from CME, there are settlement prices available for free every night (this is actually the case for much of the energy complex, for vanilla futures as well as exotics.) ICE isn’t the preferred platform for heating oil (that would be NYMEX/CME) but the ICE lookalike is based on NYMEX anyway.

Posted by AEinCH | Report as abusive

Is the NYT running some sort of “care in the community” programe?

Firstly, with an OTC derivative you need a strongly capitalised counterparty. BNY is a trustee the 23trillion is it talking about is most certainly not its money, it is money kept in trust in segregrated accounts for institutional investors. Secondly, even if that WAS BNY money then it is the legal entity that the OTC derivative buyer/seller is contracting with. As AIGFP customers found out, not much help knowing other legal entities own hundreds of billions of assets when you are dealing with a bankruptcy remote derivatives arm.

Which leads to why there tends to be a small number of dealers in any particular segment. They need to have the pricing expertise, they need the collateral management infrastructure and they need the client list to lay off some of the risk.

As for CCP being a pancea, they tend to work when the product is pretty liquid. Firstly because the jumps tend to be lower in liquid products but because it is easier to uncover prices – you simply look at the market. It also is easier to close out those products if necessary. For illiquid products, the CCP model simply doesn’t work.

I don’t believe Ms Story has simplified the story for “mere mortals”, I suspect – like her fellow writers at the NYT – she is simply too stupid to understand what she is talking about.

Posted by Danny_Black | Report as abusive

“So, the bigger the difference, the better for the bank — and the worse for the customers.” – this bit makes no sense. What difference does it make what the middleman takes? A 25mn hedge is great if the middleman is making 5k but horrible for customers if he is making 50k? Isn’t the customer paying the same amount?

Posted by Danny_Black | Report as abusive

Danny, CCP works very well in the energy sphere (clearport and ICE) even in illiquid products. Obviously real time data isn’t too easy to get for the dozens of curves listed on CME, but their settlements department does a creditable job marking these products to market for EOD – well enough that Clearport is the preferred medium of trade for pretty much all paper energy derivatives.

Posted by AEinCH | Report as abusive


“So, the bigger the difference, the better for the bank — and the worse for the customers.” – this bit makes no sense.”

Hopefully you’re being deliberately disingenuous with this comment?

Clearly, the spread between bid/ask is a potential benefit to both buyer and seller and, when the spread it skimmed by any intermediary, either buyer and/or seller is economically disadvantaged.

I used to work in a business that extracted fees from matching buyers with sellers. I can tell you that we made obscene profits by exploiting the lack of transparency in the market.

Yes, buyers and sellers could compare prices offered by our competitors and, over extended periods of time, there was some price competition that forced spreads lower.

But we were able to extract extraordinarily high margins for long periods before any competitor (usually a new entrant) started the cut-price competition.

If, as in the derivatives market described by Story, there are significant barriers to entry and thus few new entrants, I would not expect much price competition and therefore super high spreads.

But I’m pretty sure you understand that and you’re just trying to defend the indefensible…

Posted by dbsmith1 | Report as abusive


I forgot to add that, if you’re not being disingenuous, then it is a bit rich for you to accuse Ms Story of “stupidity”.

Posted by dbsmith1 | Report as abusive

dbsmith, the story isn’t describing a market with significant barriers to entry. ICE is used by thousands of trading shops big and small, and everyone has equal access to their screens. The barriers this article is describing are to the clearing association and risk committee, neither of which confers any trading advantage…maybe it affords member banks small savings in fees but nothing related to pricemaking.

Is Bank of america eg really a top user of the ICE platform? Personally I would doubt it, but then ICE has many different units (ICE futures, ICE clearing, ICE Europe etc) – the biggest problem with this piece is that Ms. Story doesn’t specify which markets exactly are being held hostage to the secret society of banks. If it’s heating oil (her example) that doesn;t hold up at all, because the CCP (cleaport) lists settlement prices for everything, even exotics like crack spreads and CSOs. I think it’s credit swaps, but she doesn;t seem to realize (or fails to make clear) that this is a tiny proportion of ICE’s overall business.

Posted by AEinCH | Report as abusive

dbsmith1, so you are saying that you were actively disadvantaging your customers during that time? They would have got a better price without you? They would have transacted just a quickly without you? A guy selling fruit to a restaurant is worse off paying a 50bips spread to sell it now than paying 5bips spread to sell it whenever? Or the restaurant is better paying 5bips to possibly not be able to buy. A fund trying to sell 5% of a small company better off paying a larger spread to a firm that buys the block in one go or is he better dumping it all on the market and paying a few cents commission?

Posted by Danny_Black | Report as abusive

AEinCH, actually I didn’t read all of the original article because it is behind the NYT paywall and so there is a very strong possibility that it was unfair to her and everything I read was out of context. That said the context you supplied makes it seem even worse.

Was she talking specifically about OTC cleared through ICE? I assumed she was talking about OTC in general.

By the way, was I was trying to convey was that illiquid means the price can go to zero if there are no bids for an extended period of time in a very short period of time as happened in parts of the credit space 2008. Usually margining works better when the price moves more smoothly.

Posted by Danny_Black | Report as abusive


“so you are saying that you were actively disadvantaging your customers during that time?”

I’m quite sure that, if either side of my deals — the buyers and sellers — knew what kind of fees I was able to extract, they would have said that I was “actively disadvantaging” them.

Note that I’m not saying intermediaries never add value — clearly they may. I’m just saying that, when there’s no immediate, transparent, price discovery, prices will be higher than they would be in a transparent market.

I could have survived quite nicely on a 1% spread instead of the 4-5% I got because no one knew all of the transaction economics except me!

Posted by dbsmith1 | Report as abusive

Not to put too fine a point on it, Danny Black, but you appear to believe that if your services add value then you get to extract whatever rent you feel like or can get away with. The clients have no right to know what your margins are (none of your damn business) or whether someone else could offer them a better deal. I suppose it doesn’t occur to you that businesses might have better uses for some of that capital, and that it makes a difference in the real economy (e.g. jobs, wages, growth, etc).

Thanks for your honesty. Same to dbsmith1, who, as a bonus, also appears to have a conscience–might want to have that looked into, as it is quite the handicap in financial services these days.

Posted by LadyGodiva | Report as abusive

LadyGodiva, sorry but in terms of price as stated above they can get plenty of quotes and are free to choose whoever offers the best **price** which doesn’t correlate with the guy with the lowest spread. To use Ms Story’s analogy, would you rather go with the guy who can sell your home for 250k with a 3% commission in a couple of weeks or prefer to go for the guy who might be able to get 200k after a few months for 1%? So by your argument, Google and Microsoft are simply leeches because they make much higher margin than swaps traders? I must remember that one.

As for charging what you can get away with, can we assume someone of your ironclad conscience and honesty has demanded they get paid 1c about starvation wages and not a cent more?

dbsmith1, not sure what market you worked in but no, transparency does not equal better price. I am sure REDI book charges less commission than Liquidnet but if I was selling a large block of stock I know which one I would choose to send the trade through.

PS Most OTC swaps traders would be happy with 1% too. You may want to check what the spreads are on IR and currency swaps….

Posted by Danny_Black | Report as abusive

Anyone who has ever witnessed a back office CDS settlements department will have seen (at all but the one or two best organized firms) a shambolic mess of spreadsheets, messy manual reconciliation, large backlogs of unconfirmed trades and can see the value of central clearing.

The market is a mess and no wonder the outstanding notionals got so ridiculously large before netting began properly after the crisis.

Being able to accurately and quickly identify how exposed the firms are to each other has to be a great leap forward.

Posted by vk9141 | Report as abusive


I just wanted to say that your opening line with Chicago Fed and OTC derivatives clearing- HAD ME AT HELLO!

I read and enjoy your posts about art, wine, nyc, and all the rest… but I think I speak for a clear majority of your readers when I say we come back BECAUSE you are such a wonky financial journalist… not in spite of it!

Keep up the great posts on Basel, CLO’s, CDO’s, all things tax… all of it.

Posted by y2kurtus | Report as abusive

@Danny Black,

Let’s recap your arguments so far: 1) Trust me, derivatives pricing is fair; and, 2) transparency=socialism.

I’ve learned so much and it’s not even lunchtime. Thanks!

Posted by LadyGodiva | Report as abusive

y2kurtus, agree with you too. Would also point out that he regularly has some very smart and knowledgeable people commenting on topics – for example in this post AEinCH.

Posted by Danny_Black | Report as abusive

LadyGodiva, try learning english too and re-reading. There are many many issues with OTC derivatives pricing and market making. The spreads are not one of them – in fact one can argue during the bubble for the risk market makers were taking on the spreads were too low, not too high. The ability to get a competitive quote from ALL the participents is not either. People in the market either use the electronic trading platforms provided or if they are voice broking they use this new-fangled device called the “phone”.

Posted by Danny_Black | Report as abusive

By the way, Duffie did a simple model of this:

http://www.stanford.edu/~duffie/DuffieZh u.pdf

More extensively covered in:

http://www.imf.org/external/pubs/ft/gfsr  /2009/01/index.htm

They call for a global CDS CCP but I remember they tried to build something like this for equities in the 90s – from recollection called Global Transaction Monitor or something like that – and it went the way of most large scale ambitious software projects.

vk9141, netting is not the same as centralised clearing nor does a CCP necessarily solve the issues you mention. There are software products that do compress trades – thinking TriOptima – without CCP. The other issue with netting is that with changing counterparty credit valuations the exposure can jump around on a MtM basis and more importantly can cause unexpected collateral calls. Also the number of exactly matching contracts is not necessarily that high. What there usually is is a tiny basis risk under normal circumstances but which can blow out under stress especially if your counterparty thinks you might go under.

Posted by Danny_Black | Report as abusive

I wrote similarly at my blog, pointsandfigures.com.

http://pointsandfigures.com/2010/12/12/b anks-clearing-and-over-the-counter-deriv atives/

Of course today the lean hog market went haywire. purely the cause of exchanges not being good caretakers to markets.

http://pointsandfigures.com/2010/12/13/l ean-hogs-jump-computerized-trading-ruini ng-marketplace/

Posted by pointsnfigures | Report as abusive

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