How Banks Make Money in Derivatives

December 19, 2010

The mystery of derivatives, the secretive multi-trillion dollar market that few understand but is believed to be at the heart of the financial meltdown needs illumination. Without it, policy makers have no chance of getting much needed regulation right.  The recent NY Times piece, “A Secretive Banking Elite Rules Trading in Derivatives was unhelpful in this regard.  What follows is intended to be a laymen’s and policy maker’s guide to derivatives practices and profits.

I am no apologist for the big banks as my readers know.  But the NY Times failed in its duty to provide objective analysis to the public in this instance.  While it’s been over a decade since I was intimately involved in the derivatives business at JPMorgan, and much has changed since then, the essential principles remain the same.  In fact, the parallels of the recent crisis to the collapse of Long Term Capital Management in 1997 are numerous, and nowhere more so than with the systemic risk associated with over the counter[1] derivatives.

There are 5 essential truths about over the counter derivatives:

  1. Derivatives can and do serve a socially useful purpose to businesses, financial firms, institutions and governments, namely the management of various financial risks including currency, interest rate, commodity, equity, and credit, plus numerous second order risks and less conventional risks.  However, in terms of volume, such legitimate “end user” risk management probably accounts for no more than 5% of all OTC derivatives traded.  Banks of all sizes and shapes are part of this “end user” demand, for asset and liability of their balance sheets for example.
  2. Market making volumes to facilitate this end user demand constitutes probably twice the volume of the end user demand since many transactions are not simply brokered, but are positioned by dealers in similar but not directly offsetting transactions.   Trading volumes expand as dealers seek to manage the underlying risk.
  3. The other 85% of derivatives volumes are either speculative in nature (hedge funds, banks, insurance companies, conventional asset managers, certain corporations, certain government agencies) or dealers hedging speculative trades they facilitate.  Modern finance’s distinction between speculation and investment has been lost in the process.  Derivatives are particularly attractive to speculators because of the efficient imbedded leverage in them.  Of course this leverage creates externalities in the form of systemic risk, and therefore must be addressed aggressively with much higher capital and margin requirements.  A Financial Transactions Tax (“FTT”) should also be imposed globally for the reasons I gave in my April press briefing in support of an FTT.  The addiction of speculation is the real story here, and we need to talk about it.
  4. First wave growth of derivatives was driven by natural end user demand, beginning in the early 1980s and lasting until the markets seemed to “mature” in the mid 1990s.  It was a great age of constructively creative finance, linking capital markets together for the first time and enhancing efficiency in the process.  But the loss of resiliency was lurking in the wings.  Second wave growth[2] was driven by the emergence of investors in the derivatives markets, which took off in the later half of the 1990s.  The hyper growth of credit derivatives in particular, reaching an astounding $60 Trillion of notional by the time of the crash, was driven largely by speculative investment demand of hedge funds, banks, insurance companies, and other speculative capital.
  5. OTC derivatives are used by institutional professionals, not by individual retail investors.  The heating oil distributor in the NY TImes article is more the exception than the rule and his desire for fair pricing can best be met via a competitive process (check pricing with at least two banks when trading).  Derivatives are usually, but not always, handled ethically, with transparent pricing among highly competitive professionals who understand the credo “buyer beware”.  Institutions who lack professional expertise, engage in derivatives at their own risk since there are many complex nuances.  Situations of unsophisticated end users getting ripped off by opportunist Wall Street pirates date back to the famous Proctor and Gamble trades with Bankers Trust in the 1980s.  However, the sinister nature of certain structured products made famous by Goldman’s famous Abacus deal (see “Goldman V. United States: What it Really Means”) makes notions of “buyer beware” look downright quaint.  It’s one thing to not know how to check a price for a trade effectively, and potentially leave a nickel (or more) on the table.  The willful deceit, what can only be called financial evil, imbedded in the security selection, waterfall mechanics, and rating agency exploitation of Abacus type deals was shocking to this former derivatives expert as it was to the public.  Apparently it does not count as fraud.

And there are 5 ways banks make money as dealers in OTC derivatives:

  1. Volume.  The immense growth of OTC flow trading means that the dealers make big money if they can professionally intermediate these massive flows, measuring in the trillions.  This involves putting capital at risk so it can and does go wrong, and professionally making tight, competitive markets across multiple instruments.
  2. Economies of scale.  While there are conventional economies of scale in areas such as systems, operations, and counterparty credit management, and a subsidized cost of capital by Uncle Sam, the really valuable economies of scale exist on the order flow side.  As the industry consolidates and market share increases, by definition the dealer sees more of the flows.  This assists in managing risk, and, enables the dealer effectively to “front run” the flow for its own trading book.  Such front running would be illegal in an agency driven brokered market such as the NY Stock exchange (until the advent of high frequency trading and dark pools – but that’s another story).  But in OTC markets, there is no pretext of such “front running” being illegal.  It’s barely seen as unethical.  It makes a lot of money for Wall Street.  There is a reason why more large hedge funds and corporations haven’t screamed bloody murder at the derivatives practices of Wall Street.  They are dependent upon them.  This represents a dangerous accumulation of power that should be addressed by our government.
  3. Proprietary Trading.  Dealers speculate on numerous risks associated with managing OTC derivatives books, and utilize the advantage their market making role provides them in seeing the flows.  It is ludicrous to suggest that this activity can be separated from market making.
  4. Complexity.  Wall Street always seeks to add complexity to the derivatives business.  On the one hand, this allows tailoring of sophisticated risk profiles, often the well-intended desire to meet client needs.  Complexity also allows high margin trades, as they are by nature, structured and negotiated rather than done via a more competitive process.  It must be said that some complexity is intended to deceive and gouge clients.  The more complex, the more buyers had better beware.
  5. Cheating.  Occasionally, Wall Street opportunists seize opportunities to cheat, some might say steal.  This is done either by direct lying, or by misleading clients into trades they don’t know how to price fairly.  This is different than the ethical and at times legal issue of selling a “client” a risky position that they don’t understand how to price or manage for the multi year life of the transaction.  Unwinding such trades when the client realizes the disaster is often a second opportunity to gouge, the deepest cut of all.

If I had to guess the percentage of money-making methods 1 to 5 above that a Goldman or a JPMorgan realizes over time, it would be 30%, 20%, 25%, 20%, 5% respectively.  Of course there are no hard lines between these categories and you wont find bank financial statements organized quite like this.

Regulating derivatives is beyond the scope of this post.  However I will say that it is essential to distinguish between the value of moving derivatives to an exchange and the value of centralized clearing.

Exchanges make pricing transparent so customers generally like them and dealers generally dislike them.  Strongly.  Exchanges enhance transparency and therefore hurt profitability for dealers.  However, large customers also like deep liquidity, which OTC markets can be better at providing, especially for non-commodity like products.  So for protecting the interests of customers, it depends on who the customer is and which products. Generalizations will be misleading.

Centralized clearing is the big gorilla in the room, and at the heart of the systemic risk that has exponentially expanded with the rise of OTC derivatives and threatened to take down the entire financial system.  Reform is at least  a decade overdue, having been called for in the wake of Long Term Capital.  How this unparalleled and ultimate “too big to fail” institution works, and who should be allowed into the network, and on what terms, should not be left to a group of 9 bankers.  Unless we follow the incoming House Financial Services Committee Chairman Bachus’ unique perspective,

“In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks,” he said.

[1] Over the counter (“OTC”) derivatives refer to derivatives that are traded among principals, away from any exchange such as a futures exchange.  Interest rate swaps and credit default swaps are examples of OTC derivatives.  The NY Times article was largely talking about OTC derivatives, although it confused the distinction.  Most experts consider OTC derivatives to be the area where systemic risk resides, which explains the desire to move much of this activity onto open exchanges with centralized clearing, similar to the way the major futures and stock markets operate.  The US government bond market operates over the counter as well, but with centralized clearing.
[2] This author participated in the “first wave growth”, and was as surprised as anyone at the incredible growth in volumes during he first decade of the 21stcentury, as were many of the practitioners I’ve stayed in contact with.  This is a commentary on the immense rise in distorting speculation in our financial markets, more than it’s a comment on derivatives per se.