Wednesday, May 14, 2008

CDS Exchange

The more I read and think about it, the more obvious it becomes that we need a CDS exchange to contain these financial weapons of mass destruction. The whole point of an exchange is that it pre-regulates leverage in a transparent way and so prevents any crisis of confidence leading to a bank run. Also, you'd think this would be a major opportunity for any of the big exchanges. Jim Hamilton has some clear thinking up on this question.
Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

Actually, I think if you follow this reason to its logical conclusion, you can start to wonder why we have banks at all -- that is, why we don't just directly allocate all capital through an exchange mechanism like the market? Why don't we just have a bond market and a stock market and dis-intermediate banks entirely? These markets could then have net margin requirements just like the futures market.

As an even more radical thought experiment, imagine what would happen if you made charging interest illegal. Instead, require all capital to be equity capital, that is, all investments are explicitly required to be a non-zero sum game before anybody gets anything. Now some people aren't going to want to take lots of risk with their capital, and they're not going to know enough to want to directly buy stock in a business, and especially not on margin. I imagine banks would re-emerge as aggregators of equity capital that then put this to work in the form of further equity, much like a mutual fund does. Their leverage would in this case be regulated by the margin requirements of the exchange, eliminating any need for futher, and as we have seen largely non-transparent, capital requirements. This is probably a delirious idea, and I'm not even sure it's coherent at the level of the entire economy, but I find it kinda interesting.

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