What is the worldview of the typical derivatives trader? As Congress moves toward regulation of the derivatives marketplace, understanding traders’ motivations can be useful to forecast how regulatory rules will effect behavioral change. It also provides a window into the thought processes of the major decision makers on Wall Street. Since the demise of Glass Steagall, the center of gravity of the banking business has shifted toward trading and away from commercial banking (lending money for profit) and investment banking (advising and arranging mergers and structuring and distributing securities offerings to raise capital for corporate America). As a result, industry leaders are now more likely to be traders than bankers.
Reform seeks to move trading activity away from bi-lateral transactions toward a cleared market that will make these trades more transparent. Financial institutions and the companies that trade with them to hedge price risks (“end users”) have sought to preserve the bi-lateral marketplace. Why do they resist transparency and uniformity? Identifying the reasons they defend bi-lateral trading will help target reform on the real problems.
A level playing field is anathema to the trader. Successful traders must have advantages over their counterparties. This is the job description. While a trader may emphasize his or her superior intellect and courage (and therefore individual responsibility for profits, especially useful in compensation discussions), these are far less important than institutional advantages. The best traders deploy those advantages effectively to secure higher trading profit.
Some advantages are socially acceptable and some are not. For instance, superior analytics serve a useful purpose – they promote an accurate valuation of commodities and securities so that capital can be allocated more efficiently. The advantage of more liquid capital than competitors is also considered acceptable. Like a gambler with a “system” which he believes will beat the casino, a trader needs sufficient cash to buy time for advantages to be realized. For instance, a trader must be able to ride out market fluctuations until his or her superior analysis plays out in the end. Therefore, a trader employed by a firm with a large and liquid capital base will have an advantage.
There are other advantages which may not be so acceptable. Some of these have become available because of the intentional transformation of businesses which is rooted in the Reagan/Thatcher era. De-regulation allowed the consolidation of bank lending and trading. As a result, the entities that provide debt capital are often also trading counterparties for the companies that participate in the trading markets. By coupling credit and trading, the trader can use the credit as to influence counterparties who need access to that credit.
Every trade involves credit exposures, risks that losses will be experienced if the opposing party defaults. Consider a swap in which a bank guarantees a future fixed price to a fuel purchaser. At maturity, the fuel purchaser will pay the agreed fixed price to the bank and will receive the current market price which it can use to pay for the fuel. If the future price decreases in the market, the trade becomes more valuable to the bank since its payment to the fuel purchaser decreases. The bank is dependent upon the credit of the fuel purchaser to realize that value. A default of the fuel purchaser and consequent failure to pay the agreed fixed price on maturity means that the value (which has already been recognized as profit under mark-to-market accounting) would evaporate. This default has the same consequence as default on a conventional loan, a loss for the bank.
Credit exposures created by bi-lateral trading can be addressed in one of two ways: a party can post cash or collateral to cover the exposure, or the counterparty whose position has increased in value can forego posting and simply bear the credit exposure.
Each bank has a finite capacity for credit exposure to a given company. The company can use the credit capacity to invest and manage of cashflow variances (for instance, seasonal differences in revenues). If a bank allocates credit capacity to trading exposures, there becomes proportionately less capacity to lend for these other purposes.
Why would a bank do this? After all, the bank could simply make a loan that provides the cash to post collateral. Convenience is one reason. However, the behavior of the market participants in the resistance to cleared markets suggests more significant reasons. It is widely known that deployment of credit capacity to trading with a company is far more profitable than conventional lending. This means that:
• the profit from a trade coupled with the extension of credit through forgone posting of collateral is far more profitable than
• the profit from a conventional loan plus the profit from a trade in which no credit is extended.
Viewed from the perspective of the company making the trade, it is either willing to pay more for the packaged deal or it does not properly evaluate the all-in cost. The advocacy for end user exemptions in the current debate over financial reform strongly suggests that these companies prefer the consolidation of credit extension and trading.
This mechanism for allocating finite credit capacity in the economy is questionable, to say the least. A trader at a bank derives an advantage from this preference. To access credit capacity allocated to trading, the company must transact exclusively with the trader. The additional profitability is baked into the trade, and thus into the performance of the trader and his or her compensation. Trader control of the extension of credit is not a recipe for long-term efficiency in capital utilization for either party to the transaction.
But there is more to the story. As profit margins in basic industries have been squeezed, the need to reduce exposure to commodity price volatility through hedges has increased. There has also been a dramatic trend toward breaking businesses into component parts. For example, a formerly integrated power utility may now be a separate generator, transmission company, wholesaler and retail distributor. Each new entity is exposed to commodity price risk where before none existed. As a result, traded markets have increased in number, but these markets are balkanized, with fewer participants in each. By coupling credit and trading, the trader can strategically establish arrangements with one or more major participants in a “mini-market,” securing a dominant position in that narrow market.
To obtain a hedge as now required to conduct business, companies become dependent on the bank trader who has secured such a dominant position. This increases the value of the other advantages the bank trader has (e.g., analytics and liquid capital). Dominance in a market is a valuable advantage since counterparties become captive to the market makers who are always available to quote a price when a hedge must be secured and price may not be the most significant factor.
Do individual banks “corner” specific markets? Perhaps so. But, more importantly, these trading dynamics have moved a significant portion of the pricing functions in important sectors of the economy (e.g., certain energy markets) into the hands of a limited number of large and sophisticated financial institutions. Given the potential for profit, is it any wonder that the leading positions at financial companies are increasingly occupied by former traders?
A trader views these advantages as central to his or her livelihood. Fairness, a level playing field and social utility are not important considerations to a trader. In fact, for a trader to perform the functions that are desirable, such as accurate pricing of commodities, this is appropriate. They “eat what they kill,” which makes them ruthlessly efficient. This is not necessarily a bad thing. Robespierre is reported to have said, “First, we behead the speculators.” Demonizing traders for doing what comes naturally similarly distracts from the real problem. Traders, perhaps more than almost anyone else, must be constrained by external rules.
However, if financial institutions continue to be primarily trading entities, the incentive to secure short-term profits by dominating markets will ascend over the need to preserve long term bank lending and investment banking relationships. Behavior that damages society as a whole must be controlled by regulation, since the leadership of the financial institutions will not curb it. If the packaging of credit and derivatives trading are considered inappropriate advantages, required collateralization through clearinghouses or other middle men would address the problem.
There is a lingering, unanswered question raised by the foregoing discussion: Why do the end users prefer packaged credit and trading deals, even though the banks make more than the unpackaged alternative? That question deserves thoughtful analysis as well. In answering this question, alternative solutions may become apparent.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.