OTC derivatives deal in delusion

November 6, 2009 12:36 am

I stopped believing in Santa Claus when I was six. Mother took me to see him in a department store, and he asked for my autograph.

--Shirley Temple

Disillusionment came early to Shirley. For most of us, life can be a painful process of trading childhood beliefs for more sophisticated adult delusions. The financial system is now clinging to one particularly dangerous delusion called the derivative.

Money equivalents--checks, plastic, electronic funds transfers, and various financial instruments--have become increasingly intangible and sophisticated. It's this total disconnect from the real world that's gotten us into dire trouble.

Derivatives are fundamentally bets on different types of risk based on underlying securities, with traders swapping one kind of risk for another they're more comfortable with. And, yes, some of these are the same incomprehensibly complex innovations Warren Buffett famously called "Financial weapons of mass destruction".

There are essentially two kinds of derivatives: One type consists of regulated, exchange-listed, straightforward bets on future prices of commodities and securities. The other, much more dangerous kind, are unregulated, custom-designed, complicated instruments traded over-the-counter (OTC) and not through an open clearing house. These are the ones Buffett had in mind.

The Bank for International Settlements has issued a startling report on derivatives. It takes us into a new world where money is counted by the quadrillion. This year, all kinds of derivatives reached a staggering face amount of $1.4 quadril-lion. The largest chunk of this was risky OTC derivatives: They jumped to almost $900 trillion. Contrast these astronomical numbers with the world's $60 trillion total goods and services in 2008.

OTC derivatives are by far the greatest single threat to the world's financial system. The Great Recession was created by the collapse of some of them--those involving mortgages--with global economic losses, according to the Asian Development Bank, of $50 trillion. This unstable, almost quadrillion-dollar derivatives mountain still threatens to bury us in another, possibly much worse economic avalanche.

Didn't anybody notice the extraordinary risk to the financial system? Some did, but Federal Reserve chairman Alan Greenspan, among others, argued persuasively against regulating OTC derivatives. After this last crash, he grudgingly acknowledged some controls might be necessary. Treasury Secretary Geithner originally proposed strong regulation but has apparently now backed away.

As a result, the House Financial Services Committee bill to finally regulate OTC derivatives is riddled with loopholes, courtesy of the International Swaps and Derivatives Association and bank lobbyists. Critics, like the new SEC risk director, have recommended that the best way to reduce OTC derivative risk is trading through a clearinghouse exchange. The Europeans are going to take this approach.

Even this seems too weak. The business of managing risk more effectively, which is what complex OTC derivatives are supposed to do, has led to global danger at an unimaginable, quadrillion-dollar level. Our goal shouldn't be to better regulate these financial time bombs, but eliminate them before they explode again.

The OTC derivatives crowd marshals a lot of sophisticated arguments. Behind all the smoke and mirrors are two simple facts: The financial system before 1980 worked perfectly well without them; and these derivatives have grown to monstrous size totally detached from the real world of $60 trillion a year.

The rapid growth of OTC derivatives--despite the Crash--has nothing to do with actual wealth production, and little to do with minimizing risk. It has everything to do with huge fees received by banks and others for designing and selling these instruments: A tiny percentage of a quadrillion is a whole lot of money.

By now, we should be as disillusioned about OTC derivatives as Shirley was about Santa. It's long past time to recognize them as dangerous delusions, wind them down, and move on.

Paul Metzger, formerly on the Federal Reserve Board's staff, was director of financial and legal studies at the University of Maryland's graduate school. His column appears on the first and third Fridays of the month. He can be reached at pmmva7@gmail .com.