Where Is The Derivatives Exchange?

The weekend edition of the Wall Street Journal contained an article discussing the failure of Congress, over a year after Lehman's bankruptcy, AIG's seizure and nearly two years after Bear Stearns' collapse, to create a derivative exchange.

Recall, if you will, that government interventions were based, at the time, on the unknown size of risks to the financial markets and, presumably, the economy, from allowing derivatives contracts to fail.

Yet, here we are, on the brink of 2010, with no new derivatives exchange in place.

Why not?

The article recounts the various actions of derivatives customers, brokers, and sellers. But buried in the piece is the one really simple fact that explains it all,

"For Wall Street, switching to exchanges would have cut their profits in a lucrative business. "Exchanges are anathema to the dealers," because the resulting price disclosure "would lower the profits on each trade they handle, and they would handle many fewer trades," said Darrell Duffie, a finance professor at Stanford business school."

That's it in a nutshell. After taking government handouts and the benefits of zero-rate fed funds, a number of financial service firms blocked Congressional attempts to replace the risky current practice of largely unsupervised, party-to-party credit derivatives trading with an exchange.

The direct benefits of exchange-based trading, of course, is that counterparty risks are assumed by the exchange, which monitors and demands adequate collateral, plus clears and settles each day's trades.

This allows risks to be more easily known, margins to be set and enforced, and the prospect of endless daisy chains of loss from one failed contract to be eliminated.

But the price of this systemic safety, of course, is always the profits of an inefficient market.

No financial product which has moved to exchanges has ever gotten more profitable. In fact, Wall Street firms dream up innovative products primarily to escape the low profit margins of widely-traded products. This is essentially what Paul Volcker was suggesting in his recent remarks about financial innovation at a Wall Street Journal conference.

As a recent Journal piece on which I wrote this post was correct, we were originally told that AIG had to be saved due to derivatives exposure for the entire financial sector.

If the administration has changed its mind, then an explicit accounting of just what was the risk would be in order.

If not, and we need a derivatives exchange, then one should have been in place by now. We certainly have enough existing models to quickly develop one for credit default swaps and related derivatives.

It is no longer a partisan issue. One of the functions of government is to handle issues like this. That a functioning derivatives exchange has not yet been made operational is shameful.

We pay taxes for a government to provide basic services. Instead, last year, we witnesses billions of taxpayer dollars paid to avoid, we were told, financial sector disaster due to failed derivatives contracts.

It's about a derivatives exchange was in place. The systemic costs of our federal government fumbling with the consequences of not having such an exchange are too great too allow remaining investment banks and brokers to retain high profit margins on derivatives.