hi everyone I think we're going to get
started about 2/3 of the faculty members
in the room apparently have to go teach
a class well different classes at about
1:30 so we're going to get going pretty
quickly and for those of you who don't
have this is not some sort of organized
protest
I hope first challenge of the day is
moving the cursor so thanks everybody
for coming today this is a bit of a
strange project that I'm going to
present today I'm not entirely sure what
it is whether it's a paper whether it's
a book whether it's a teaching aid or
whether I'm actually trying to say
something that might be a little more
profound chances are they're not but I
don't know for sure just yet the reason
that I originally embarked on this
project was I was still a little
disappointed with many academic
treatments of how derivatives actually
work depending on the type of textbook
or a type of article we're talking about
we see vastly different presentations
about what derivatives are one based on
a derivatives are kind of like equity
securities in that they trade in deep
and liquid markets the sort of arm's
length finance view of the world and one
that used them quite squarely as
executive debt contracts that may have
equity like features attached to them
so one an equity based world public
equity based world at that and one a
more debt based world I and how I'm
attempting to make sense of that in this
paper is that especially when things are
going well given some trends I'm going
to talk about today derivatives do often
have many of the same characteristics as
highly liquid equity or
Security's so shares or bonds but when
things go bad and I'll talk about the
difference between good and bad a little
later on we start to see the debt-based
elements of derivatives come to the fore
and that all of this has a number of
enormous policy implications in terms of
how we treat derivatives but also in
understanding the social desirability of
good time derivatives versus bad time
derivatives and whether we think we need
to do something about that so the
conceit at the heart of this paper at
the moment is that one of the ways that
we can understand this sort of
distinction between good times and bad
times is by dividing derivatives up into
their constituent elements and then
seeing how these different elements
interact with one another and I'll go
into all of this in a bit greater detail
I'll come back to this set up at the end
but it's useful I think to have this in
your mind as we go through so I'm
creating my own periodic table of
derivatives elements in effect and the
first thing we're going to talk about
today is contract and derivatives
exhibit some of the most sophisticated
state contingent contracting in the
financial world relating to things like
basic payment and delivery obligations
collateral requirements and closeout and
payment netting what we also see is the
extensive use of property rights however
and specifically in relation to the
collateral that's posted against the
obligations the contractual obligations
used in derivatives markets and then and
this is where we sort of see a shift in
derivatives we also see some pretty
extensive non-contractual non property
non legal mechanisms used in these
markets this code this observation goes
back to a couple of things first my own
experience working in these markets but
more importantly my conversations over
the years with derivatives traders
derivatives lawyers at the height of the
financial crisis where what we saw was
very little formal enforcement of
contracts even when they were out of the
money because of the reputational
constraints that were created on the
xpect
future dealings we're all going to come
out of this crisis someday and that
litigating to get a short-term gain now
could have longer-term reputational
effects if we become or if we get a
reputation as a litigious counterparty
when the system is at stake
and so one of the things that I'm trying
to grapple with in this paper then is
understanding when we see contracts and
property dominates and when we see
reputation and the expectation of future
dealings these informal mechanisms
dominates in the context of binding
counterparties to derivatives there's
another element here this is actually
something that is fairly well documented
in the literature is that a lot of the
way that the contract and property
rights work specifically around
collateral and closeout netting rely on
extensive legislative regimes that
exempt the operation of these mechanics
from applicable corporate bankruptcy law
I'm afraid that up because I'm not going
to talk about it too much today except
to point out the bits of derivatives
contracts where it's immediately
relevant and what I'm going to suggest
to you guys is that we can see a pattern
a general pattern not followed in every
case but a general pattern where each of
these elements if you will bind and on
the left hand side we have states of the
world where nothing happens so we see no
observable changes in market or
counterparty credit risk and they're all
the contract really does is provide a
blueprint for what obligations are
supposed to be performed and when as we
move into observable changes in market
counter market and counterparty credit
risk the contract also has things to say
there but we also start to see the
importance of property rights playing a
role in insulating parties from risks
specifically in the form of initial and
variation margin then we enter the
interesting stuff where we start to see
non observable changes in market and
counterparty credit risk where we start
to see more unfund 'mentally uncertainty
or instability in the marketplace here's
where relationships and the expectation
of future dealings can actually play a
role in this kit this role can be a
double-edged sword so it can provide
parties with flexibility to overcome
problems that are
as a result of this uncertainty or it
can become the thing that when it breaks
down actually becomes the trigger for
financial instability why because once
relationships become important to
holding a relationship together when it
falls apart we find ourselves in a
position where parties face their own
solvency constraints and there we start
to see the breakdown of these markets so
on the left hand side we can think of
this is being effectively arm's length
financing on the right hand side we
start to see more relational financing
and then once we get to a critical mass
and I'm not sure where this is once we
get to this critical point where markets
start to break down all of a sudden we
see binding legal constraints start to
play an important role again especially
at the point where derivatives
counterparties encounter insolvency all
right so I want to briefly start out
with what I think is the anatomy of
derivative contract for those of you who
have read some of my other stuff
apologize for being slightly repetitive
again I'm a little bit dissatisfied with a lot of the academic literature and
understanding what derivatives are and
what they're really trying to do I'm
talking about a diverse range of
instruments all of which historically
would have been called over-the-counter
derivatives so these I dislike the name
but there you have it the defining
feature of these agreements is that
they're not exchange traded futures as
we'll see exchange-traded futures
actually exist at the far one end of the
spectrum of derivative contracts where
through the process of exchange trading
and clearing you've completely
eliminated the relational aspects of
derivatives contracts so you've got the
fully commodified version of derivatives
contracts I'm dealing with contracts
that are bilateral contracts they are at
least in some ways bespoke even if it's
just the identity of the counterparties
that the contracts and they take all
these various different forms and don't
worry we won't actually go into now what
I think are the most important aspects
in terms of understanding what the risks
are in derivative contract really come
down to two things
the first is market risk so what I've
got here is just a plain vanilla
interest rate swap for those of you who
are maybe less familiar with derivatives
I've got two counterparties counterparty
a and B and the essence of their swap
contract is that one agrees to pay a
fixed rate every given period so in this
case every six months for five years and
the other one agrees to pay a floating
rate and then every six months they
calculate both rates obviously the fixed
rate is the fixed rate they calculate
the floating rate they net out the two
and one party owes the other money and
you could also have derivatives that are
physically settled using some sort of
commodity or instrument but I'm going to
abstract away from that for the moment
and simply note that in this particular
example so fluctuations in the rate of
the London interbank offered rate or
LIBOR is the representation of market
risk so the fluctuation of some sort of
variable or underlying asset up or down
volatility in effect is the essence of
market risk and as we'll come on to in a
moment market risk is ultimately what
you're trying to take in the context of
derivative however there's another risk
and I think a far more important one in
understanding the structure of
derivatives contracts themselves and
that's the fact that if I promise to do
something semi-annually over a period of
five years
my counterparty is vulnerable to the
risk that I'm unable to do that so in
effect I'm taking on counterparty credit
risk that whatever contractual
obligations my counterparty takes on
will be performed in due course this is
obviously a function of time spot
contracts don't have this feature equity
securities bond trades also don't have
this feature insofar as there's only a
very brief period between the execution
of a trade and settlement this is a debt
specific and an executor a debt specific
type of feature and as we come on to is
really responsible for 95% of the
mechanic
underpainting derivatives contracts so
the takeaways that I'd like everybody to
take away from this are first that
there's this distinction between market
and counterparty credit risk and it is
unique so a question that I get asked
all the time what about a bond right
doesn't a bond have both market risk and
credit risk attached to it absolutely
right but they're completely identical
in that particular case the market price
will reflect credit risk and there's no
way of separating them other than
actually creating a derivative contract
that is designed to separate them out
into their constituent elements in a
derivative market and counterparty
credit risk ideally are perfectly
uncorrelated and unless you enter into a
derivative agreement with your
counterparty that insures you against
their account that counterparty is
default they will be separated to some
certain degree and the important thing
here is that you can be perfectly in the
money from a market risk perspective but
your counterparty fails and now you're
out of the money so the contract says
you win bankruptcy says you lose and so
that there's this distinction and a
tension between market and counterparty
credit risk that I think makes
derivatives different at least
derivatives broadly defined different
than most other financial instruments
the second thing is that nobody really
wants counterparty credit risk right I'm
seeing there's quite a bit of academic
literature out there that says people
want to take on counterparty credit risk
outside certain regulatory capital
arbitrage scenarios I think it's pretty
safe to say that counterparty credit
risk is just the evil byproduct of using
derivatives to take on some sort of
market risk and again this is pretty
important and I think what evidence is
this most of all is that what I'm going
to talk about next are going to be all
the different ways that derivatives
contracts attempt to eliminate
counterparty credit risk in order to
make the play on market risk as pure as
possible and the last thing I want to
point out is that derivatives are debt
these are executor debt contracts that
have future IO use attached to them and
so in the process of sort of
understanding what the regulatory
implications of the widespread use of
derivatives are it may not be just
issues about market transparency
equity markets that were interested in
it may not be sort of dedicating the
regulation of derivatives to securities
regulators as is largely done in the
United States that is optimal debt we
tend to think of something as raising
Prudential concerns that is traditional
bank Prudential Regulation concerns and
I think that's something that ultimately
is important to keep in mind okeydoke so
and this little bit is going to be a
little bit for those in the room who are
less sort of Fame with derivatives but I
think it's important to understand some
of the basic contractual architecture
before we launch into our distinction
between good times and bad times most of
this architecture again indeed all of
the architecture that I'm going to talk
about is about how the counterparties
attempt to manage this counterparty
credit risk but so the first thing they
do is payment net so in my original
example here I have counterparty a and
counterparty B they have one contract
I've already talked about a certain type
of payment netting that is to say that
the fixed-rate going to counterparty B
and the floating rate going to
counterparty a are often netted on
effectively a single contract basis such
that only the party that is out of the
money has to pay on any given settlement
date but if a and B had multiple
contracts their contracts also enabled
them to elect that across all of those
contracts they can globally net out so
that and I've given a arithmetic example
here so if you've got two contracts
where each party is in the money on one
contract and out of the money on another
contract
I can elect that we net globally through
all of those contracts and only one
amount is paid this is all done by way
of contract specifically under these two
master agreement that I'll talk a little
bit about later on the second thing that
we can do is have closeout netting so
aside from payment netting we may live
in a world where our counterparty
defaults and what closeout netting
enables you to do is then immediately
terminate that contract calculates in
affect the closeout value of that
contract and then have that paid out so
the depending on whether it's the the
non defaulting counterparty the
defaulting counterparty that is in the
money
we see a contractual rule that in effect
tells you who gets paid how and when
this as I said its contract it's also
though and here's the first point where
legislation comes into it you might
think yourself jeez so a party defaults
maybe it goes bankrupt and all of a
sudden my derivatives counterparties are
able to terminate that contract
immediately calculates an amount owing
and have that paid that sounds like on
its face like it violates certain
process rules in insolvency law namely
the automatic stay and fraudulent
preference rules and in countries like
the UK indeed jurisdictions like the
European Union what you see are very
bespoke legislative regimes that are
designed to carve out these specific
mechanisms from the application of those
rules so in this case we see contract
supplemented by legislation that gives
effect to those contracts and then the
third mechanism and one that we're going
to spend a lot of time on today is
collateral there are two types of
collateral in derivatives markets the
first is initial margin this is a space
that contractually is evolving quite
rapidly a generation ago in a derivative
generation which I suppose is less than
a human generation ago initial margin
was just about the risk of counterparty
default so if you and if horse and I
entered into a derivative contract
initial margin would reflect the
probability that either horse or I would
fail so it would be static and set at
the outset of the contract in the wake
of the financial crisis however a lot of
initial margin terms now have a variable
in them that's reflected in changes
under Basel three capital requirements
that say that well nope we're going to
monitor horse denies credibility or
probability default over time and we're
going to adjust this initial margin
periodically you know
to account for those changes and there's
a we can talk quite a bit about that
actually if people have questions later
on in terms of what precipitated that
change in methodology but the basic idea
is that this initial margin or the
initial amount as its termed under the
contracts is generally thought of as
designed as a response to counterparty
credit risk the second type of margin
that we have is variation margin and
here we have a very specific focus on
changes in market risk
so in between settlement dates obviously
the price of the underlying asset can
fluctuate up and down and the parties
can insulate themselves against those
fluctuations by having variation margin
applied on a periodic basis so they can
do it if they like every three months
they can do it every 24 hours really
under the in this bilateral world
there's no limit on the extent to which
the terms of this variation margin can
vary both in terms of timing but also in
terms of the amount of collateral how
it's calculated and things like that
but the key for our purpose is putting
aside all the the technical details is
that this collateral both initial and
variation margin is a hybrid creature of
both contract and property so it's
contractual always in the sense that it
is contract that then contemplates when
property rights will need to be
transferred under a derivative agreement
to secure either counterparty credit
risk exposures or market risk exposures
and then in some jurisdictions depending
on the type of security interest system
or sorry the type of in effect property
transfer use system that you have
whether it's one based on exchanging
property or exchanging security rights
in property we see this attempt to make
everything as self executing as possible
again using legislative regimes so if I
use property for example if I say to
horse okay you are out of the money on
this contract and I want you to transfer
me collateral I take ownership of the
collateral at that point and I have the
property
writes in it and can sell it do whatever
I want with it
under some regimes however how it would
be done would be that horse would grant
me a property are sorry a security
interest in that collateral but horse
would still own and have possession of
the collateral what legislation done
does in that case is that if horse goes
bankrupt again procedural laws under
bankruptcy law apply and under normal
circumstances I couldn't then go out and
enforce my security interest and get
that collateral back so we see
legislative regimes that are designed to
enable me to do that to treat that
contract right and security interest
combination in effect is a form of
property alright so that's the basic
make up the what I've called the anatomy
of derivative contract mostly based on
understanding counterparty credit risk
and the various responses to it designed
to illustrate both the distinction
between market and counterparty credit
risk but more importantly that these
contractual mechanisms also contain
elements of property legislative regimes
in them and start to look more like
executor debt contracts than anything
that we might see in the world of shares
or bonds now the next thing I want to do
is talk about how all of this plays out
under different market scenarios for
those of you that read the paper you'll
see that this is still a work in
progress as denoted by the fact that
I've stuck my definition of good time
and bad time bad times in an appendix
because I can't really figure out where
it goes yet in this paper shorthand
however good times are where market
prices are observable where changes in
the price of the underlying and in
counterparty credit risk are observable
either through changes in market price
in the case of the underlying or things
like changes in credit rating or other
proxies for counterparty credit risk and
bad times are really the opposite of
that effectively where we start to see
information problems and markets and
they begin to break down so let's look a
little bit about derivatives in good
times and specifically how things have
changed over the last 20 or 30 years
that have I think framed this idea that
derivatives
markets are becoming increasingly more
like arms-length financing and less like
loans or other executor a debt contracts
I'm gonna look at three different sort
of facets of this first the basic
payment delivery obligations and then
two things we've talked about a bit
already these collateral support
arrangements so that the process by
which collateral is transferred between
counterparties and closed that netting
so the first thing that we've seen is
the standardization of the basic terms
of these contracts under the auspices of
the International Swaps and Derivatives
Association so we see these two master
agreements in all their various guises
for different types of derivatives being
by far the most dominant contract form
estimates are a bit dodgy but about 90%
of the market if not more are documented
in is the agreement um the contractual
structure is interesting and feeds into
this idea that these things are becoming
increasingly commodified so we have for
the most parts under these agreements a
very basic modus ponens if-then
structure right like it's the economists
dream of classic state contingent
contracting if LIBOR interest rates are
above X then Y party will have to pay
Zed party a given amount this is also
supplemented by what I would call sort
of overtime contractual learning about
various scenarios that arise that
initially were not dealt with in the
contract but become embedded in the
contract as a result of disputes that
have arisen some of the best examples of
this are often things like freezing
assets as a result of orders in our
jurisdiction so the United States
freezing Libyan assets and Iranian
assets have given rise alone into a
wealth of case law dealing with well
what the heck happens when the
government intervenes and all of a
sudden I can't get access to my cash I
can't pay you in the normal course of
business under this derivative contract
and what you see then are detailed terms
that are designed to dictate
happens in exactly that scenario so we
see the gradual this incremental sort of
increase in the number of state
contingent terms as we learn through
case law about what can go wrong and I'm
able the parties then to deal with that
through stake ins in your contract and
again if you look through the history of
this the two big problems that arise
then this is now reflected in the
contractual architecture our capital
controls or asset freezes and also
physical delivery problems so our modern
world of financial derivatives was
preceded by a world in which physical
delivery of underlying commodities was
often an important part of what
derivatives did and you see then very
detailed contractual terms arising
around for example the quality of
delivery of grain onions things like
that where they have particular storage
problems where there are problems with
quality that might arise and you see
very detailed contracting around things
like well you can deliver a hundred
units of grade-a grain but if you can't
get your hands on a hundred units of
grade-a grain you can deliver 125 units
of grade B grain and so on and so on and
so forth designed in effect to
encapsulate as many circumstances as it
possibly can
next I won't go into too much detail
here except to say that there's also
quite a bit of State contingent contract
in governing the circumstances where
parties will be required to post
collateral this includes both the basic
initial and variation margin
requirements but also things around how
to calculate what those margin
requirements are at any given point in
time and as we'll see later on this is
one area where it's actually quite
possible to find yourself in a world
where it's difficult to use detailed
state contingent contracting ex-ante in
order to resolve these problems
specifically what happens if you don't
have a market price and you have to
calculate collateral requirements and
we'll talk about that a little bit later
on lastly we have closeout netting and
here if there are any derivatives
lawyers in the room you can feel my pain
here is where lawyers really really get
into the nitty-gritty of all the various
things that can go
that lead to either a termination event
under a derivative agreement effectively
an event where nobody's to blame but we
still want to terminate the agreement or
an event of default which is effectively
where there's been a material change in
one party's ability to perform its
obligations just to give you a flavor of
this this is section 5 a 7 of the 2002
is the master agreement this is the
definition of bankruptcy for the
purposes of the is the master agreement
it has I think 15 separate heads that
define what a bankruptcy event is and
even then it's still one of the most
litigated provisions in all of
derivatives agreements so we see
incredibly detailed contracting at the
same time we still see enough incomplete
contracting that there is litigation
designed to clarify these terms all
right the standardization this
incremental growth of state contingent
contracting added to then the
standardization under the auspices of is
de has facilitated a good deal of
automation in derivatives markets I
don't have a lot of time to go here what
sort of precipitated this the last time
I was in derivatives markets most of
this was manually done so you would get
a fax from your counterparty you'd look
at it and your compliance officer would
sign off on whether it had the right
terms and fax it back when you're
talking about several thousands
agreements a month that becomes a pretty
big headache quite quickly and in fact
this came to a head in about 2004 2005
with credit derivatives as a result of
which the Federal Reserve Bank of New
York
I suppose spearheaded an initiative
designed to overcome this paper
processing problem with the result that
we see an increasing proportion of
derivatives cleared and settled through
automated processes unfortunately this
is some data that I've collected on the
basis of bis and is the surveys
unfortunately of course because the
problem only really came go ahead in
2005 detailed statistics when we started
in 2006 what you would see and
unfortunately have to take my word for
it
if you could go five years back in time
on this chart would be somewhere
definitely south of 20 and probably
pretty close to zero and what was above
zero would just be the industry leaders
at the time starting to implement
automated processes while most of the
marketplace was still not automated and
even then really only with the most
popular liquid products of things like
forward rate agreements and interest
rate swaps so we've seen and the red
line is the important one here we've
seen an increase from about 55 percent
in 2006 to about 77 78 percent so about
a 50% increase in automation over the
course effectively over the last decade
knowing I don't have a theory for that
at all
to be honest yeah I mean the the data
doesn't really give you too much of an
insight into that it's certainly
possible that what happened was that
compliance resources were being devoted
elsewhere during this period in effect
right it could also be although even
then I'm not sure that hypothesis bears
out because if you look at the
derivative sorry the Lehman bankruptcy
reports Lehman Brothers who you might
think would have been poor at
derivatives risk management actually
didn't have any open positions
so these unn electronically confirmed in
settled positions so it was doing pretty
well in this regard or didn't have any
sorry I'll be more accurate there it
probably had manual processes in place
for some derivatives but nobody
challenged any of those manual processes
the yeah some of the think about I
haven't really put too much thought into
it all all right the last thing in
probably the thing that everybody knows
about at this point about derivatives
and good times the shift from bilateral
towards central clearing so it used to
be the case that the vast majority of
derivatives existed in this dense
thickets this network of derivatives
dealers and other counterparties
everything was done on a bilateral basis
and then portfolio hedging took place at
the institutional level in effect
typically on the balance sheets of
derivative dealers investment banks
primarily and then for reasons that will
come on to there was this shift already
taking place in many more standardized
derivatives markets prior to the crisis
but incentivized even more so by the
adoption of the dodd-frank act title
seven in the US and the European market
infrastructure regulation in Europe that
has instigated this shift towards
central clearing now the reason for this
is sort of twofold the first is that by
re routing derivatives trades towards a
central counterparty you can collect a
lot more data about how the markets work
so not surprisingly the clearing mandate
was accompanied by a mandate that
required a lot more detailed reporting
although I certainly think not detailed
enough given the Prudential risks
associated with derivatives to
regulators to the CCP's to enable them
to manage risk and then the second thing
was that clearing houses are able to
coordinate then the mechanisms so the
netting Arrangements the collateral
requirements and closeout netting and
other crisis management tools in the
event of market disruption or
institutional failure and the reason or
the mechanisms by which they do this are
often known as a clearinghouse default
waterfall we don't really have time to
go into it in any great detail today but
there are two things I want to note the
first is that all transactions of a
particular type with all counterparties
righted through a CCP are subject to the
same rules so you don't get bilateral
bespoke negotiation and the second thing
is that in relation to things like
collateral requirements is that they
strictly enforce daily or even more
frequent variation margin requirements
so changes in the fluctuation of the
market price of the underlying are
reflected in the margin requirements
very rapidly such that in theory at
least there shouldn't be large open
exposures as a result of changes in the
price
of the underlying this is then coupled
then if this is about managing risk
between the CCP and a clear member the
allocation of risk depending on which
way it flows there's also risk
neutralization mechanisms and
clearinghouses specifically once we get
to things like pre committed insurance
funds clearing member and Clearing House
capital and contingent capital calls and
then things called position portability
procedures where effectively the
Clearing House can compel clearing
members that survived the failure of
another clearing member to take on the
positions of the failed member and we'll
talk a little bit about that again later
on why did I just tell you all of this
well when you put it all together when
you take this standardization when you
take the automation when you take the
shift towards central clearing and the
standardization and automation that come
with that
all of a sudden derivatives instruments
start to look more and more like liquids
standardized highly homogeneous products
they start to look more like
conventional equity and debt securities
where we can in a sense if we let
ourselves be fooled think that all of a
sudden the only things we have to do now
or make sure that people have access to
price transparency and other sort of
market supporting institutions what I
want to I guess the the real takeaway
from today is then this trend though
true disguises most of what happens in
the way that derivatives work during bad
times and again insofar as I've done
anything so far in framing the
difference between good times and bad
times I'm talking about situations where
we can no longer see prices I'm talking
about situations where I start to doubt
that horse my counterparty is solvent
I'm talking about situations where maybe
the circumstances around me are
tumultuous at a market level and I don't
know where risk is going to come from is
it going to come from the underlying
assets is it going to come from my
counterparties is my counter party going
to fail because of its exposures to
other counterparties these are the sorts
of scenarios that both create huge
information costs and uncertainty for
market
but also become I suppose fertile ground
for exposing how incomplete derivatives
contracts actually are at the end of the
day so for all the sort of state
contingent contracting that we've talked
about for all the details that have been
put in these two master agreements all
the jurisprudence that is then filtered
into honing and revising is the master
agreement there's just no way on earth
that these contracts are entirely income
entirely complete we know this because
we see the cases we know this because of
case studies like the one that I'm going
to talk about in a minute
involving the renegotiation between AIG
and Goldman Sachs and we kind of know it
as a matter of economic theory because
the cost of writing truly complete state
contingent contracts can be extremely
high I this includes both sort of the
upfront costs of actually determining
what all the different states of the
world are and then writing contracts
that actually allocate risk and dictate
payoffs in each of those potential
states there's also the cost from a
contractual perspective ex post of
actually enforcing our complete
contracts in the event that we're able
to write them so it's not surprising
that our contracts are incomplete given
all these costs but that has important
implications in terms of how derivatives
work during bad times the risks that
this creates and you know economic sort
of the economic theory of contracting
sort of identify are one that we could
get suboptimal outcomes so we'll either
not say what the parties are supposed to
do or what how risk is supposed to be
allocated in a given state of the world
or two we might open ourselves up to
opportunism so if everybody's equal in
this state of the world where we don't
know how we should act because the
contract doesn't specify it it may be
the case that were just incentivized to
renegotiate but where there are a
symmetries and information of bargaining
power we might think that one of the
pound one of the counterparties might
use that in order to renegotiate the
contract in a way that enables it to
extract value for
counterparty uh thankfully the the same
economic theory of contracting
literature that identifies these
problems also identifies sort of broadly
the classes of solutions that we might
find so we see the use of property
rights
so rather than contract we can just
allocate property rights the key benefit
of property rights in this case is that
effectively enables self-executing
enforcement I don't need to enforce my
contract I own it I have the ability to
do with it whatever I want the second is
the allocation of decision-making rights
so if my contracts incomplete and a
state of the world arises that exposes
that incompleteness the allocation of
decision-making rights enables one party
to actually say what needs to be done we
get clarity by virtue of the fact that
one of the parties now clearly has
decision-making authority now there's
obviously some really thorny questions
here that I won't fully avataq a chance
to address today namely how do you
allocate decision rights to the best
party in the circumstance of that
incompleteness how do I tell ex ante who
should get authority ex post and there
are huge issues surrounding that that
make this a very difficult type of
strategy to implement successfully and
one that when we come to the AIG goldman
sachs story minute we'll see was not
particularly done all that successfully
and then lastly we have standards based
contract so rather then dictate specific
terms we can identify standards that a
party is required to meet in the course
of dealing with whatever uncertainty
whatever in complete contracting exists
during those contracts evidence all
three of these things just very quickly
so property rights well we allocate
collateral to counter parties with
larger exposures so both initial and
variation margin can be viewed as in
effect shifting property rights in the
event that the exposure of a
counterparty becomes heightened as a
result of changes in market or
counterparty credit risk as we'll come
on to in a moment
there are decision-making rights most
importantly in this case the use of
something called a value h valuation
agent designed to calculate the
applicable collateral requirements and
then lastly we have a whole host of
standards-based contracting enough to
keep you know commercial litigators in
business in perpetuity we see this in
circumstances where we might expect to
see it to be honest so we see it where
the valuation agent typically the dealer
in a transaction is given authority to
calculate margin requirements where
they're required to act in good faith
and in accordance with standard market
practice why well because being a
valuation agent especially if we can't
observe market prices comes with a lot
of power and in this particular case
using standards based contracting
provides at least in theory some sort of
check on the exercise of that power
namely it has to be exercised in the
standards of good faith and in
accordance with standard market practice
we also see it in payments where we see
things being made in customary manner
for those of you who are payment systems
geeks which probably only includes me
the rate of change in payment systems
and settlement systems is so fast that
to dictate in detailed terms how
payments should be settled is to just
ask for trouble
so customary manner covers all different
types of mechanisms that you might get
they vary across jurisdiction they vary
across time they vary across different
types of derivatives products so given
that heterogeneity it makes sense that
we see standardization of this term
around customary manner of payment
lastly and for those of you and I think
there's quite a few of you here today
taking principles of financial
regulation we see standards-based
contracting in relation to compliance
with regulatory requirements regulation
of derivatives and their counterparties
move so fast that having somebody
maintain authorizations across a
detailed list of different types of
regulations would be suboptimal
certainly very hard even to keep up with
and so having a more general
standards-based term that says that they
have to maintain all our reasonable
efforts to maintain all government
authorizations makes a lot of sense kind
of basic contracting stuff but nice to
see it actually play out the theory play
out in the context of derivatives
markets lastly and here's where I'm
either going off the deep end or perhaps
saying something
is that even after all of those
mechanisms there's still something left
so collateral it's quite expensive
valuing financial assets using the
valuation agent mechanism it's actually
quite a subjective process and one we're
identifying true price especially with
more esoteric less liquid instruments is
actually something that's not undisputed
and of course when it comes to
standards-based contracting you've got
to go to court to enforce them so
there's this role then given the cost
associated with these mechanisms for
relationships to play a meaningful role
in the context of derivatives contracts
at least in theory what I'm going to
talk about next is that theory in
practice for those that may not be
familiar I am drawing a distinction here
between two types of relational
mechanism one between the expectation of
future dealings which is that Horst and
I expect to do business in the future
and how Horst behaves towards me will
dictate my behavior towards Horst and
the other one is reputation so how Horst
behaves towards all of you will
influence how I behave towards Horst and
this is going to be important to
understand how Goldman Sachs saw its
relationship with AIG versus its broader
relationship with the marketplace okay
okay so to illustrate this relational
dimension of derivatives contracts and
I've gone back to really a treasure
trove of information released by the
Financial Crisis Inquiry Commission that
included a large volume of email
correspondence between AIG and Goldman
Sachs in relation to its I guess well
about thirty-five I think are so
derivatives contracts on multi sector
CDOs so these were credit default swap
contracts where AIG was effectively
offering credit insurance against
defaults under various CDOs linked to
the subprime mortgage market and we have
really a large volume of correspondence
that takes us from the period where we
start to see distress in the subprime
market through to the period
and after the period where AIG received
support from the federal government in
September 2008 so the basic idea of
these agreements was that AIG provided
credit protection in exchange for which
Goldman Sachs paid AG a periodic C we
also have some of the more detailed
elements of these contracts thanks to
the FDIC so there were three collateral
triggers in the AIG goldman sachs
contracts so these were events which
would require AIG to post collateral to
goldman sachs the first one was that
there was a change in the ceo's credit
rating so if the credit rating was
notched down that would trigger
collateral the requirement to post
collateral if the CDOs price went down
by four percent or more that would
require AIG to post collateral and if a
IG own credit rating was downgraded that
would require AIG to post collateral
this created quite a pro cyclical
dynamic there's quite a bit of writing
on this we can talk about a little later
on this part of the market has changed
dramatically in the wake of the
financial crisis precisely because of
this exact case study interestingly the
valuation agent mechanism in the case of
the the edgy goldman sachs contracts was
that both parties with a valuation agent
I've never in my life seen that before
and it may to a certain extent explain
what happened next I'm not entirely
clear that I've talked to a I geez
general counsel from that period about
this who didn't hadn't noticed this
aspect of the contracts it's strange
that you would allocate decision-making
authority to both parties because that's
kind of like having a a joint venture
agreement where you have a 50/50
interest and as soon as there is a
dispute you just get deadlock and in
this particular case we also see a
threshold amount so the amount of
collateral that had to be posted had to
exceed or the loss or II had to exceed
75 million before a AG would be required
to post collateral and importantly at
least the agreement said that once
that's triggered gold a AG has to post
collateral within two business days
effectively 36 hours but in fact two
business days and then lastly if there's
disputes under this agreement
specifically as it relates to the
pricing of the contracts or collateral
this had to go to a dealer pool this is
a pretty common provision it basically
says that if the valuation agent has
given a mark on collateral or the price
of the contract that the other
counterparties agrees with the dealer
has to go to the marketplace and solicit
four or five other dealer quotes and
that the arithmetic average of those
dealer quotes becomes then the price
that's relevant for making a
calculations under the contract this is
going to be quite important to the
moment all right then so obviously most
of us if not all of us know the story of
what happened next
what happened in the subprime mortgage
market certainly didn't stay in the
subprime mortgage market and we see the
triggering successively of each of the
requirements under the credit support
agreement for AIG to post collateral and
in July 27 2007 we see Goldman request
1.8 billion dollars worth of collateral
from AIG this is obviously not a small
amount this is a very large amount
especially for firms that you know are
engaged in putting capital to use rather
than having it sit on their balance
sheets for the purposes of for example
paying out variation margin requirements
by September 2008 that 1.8 number will
be increased to about 9 billion making
it I think pretty far in a way the
largest collateral call in the history
of the world so we're talking huge
amounts here now the interesting thing
from my perspective I think is what
happened next so what happened after the
1.8 billion dollar collateral call in
July 2007 I on the surface of it it was
a renegotiation
AAG didn't pay this amount it ultimately
paid incremental amounts toward a full
amount ultimately I think it paid about
6.5 billion but significantly later
months months later not the 48 hours
that it no
they had under the contract and there
could be several reasons for this the
first thing the most famous one is that
there was a lot of uncertainty and
disagreement about the price of the CDOs
so if the collateral requirements were
linked to the value of the CDOs then the
value of the CDOs
if it's not observable in the market
place become something that's a point of
contestation and that's exactly what we
see
while Goldman was able to mark several
of the CDOs to market some of them had
had to use its own internal valuations
for and it was those internal valuations
in effect that AIG was contesting in a
in its own unique way as we'll come to
see as inaccurate as it turns out AIG
was not doing its own calculations to
compare against Goldman Sachs so it
looks like those objections were just
well we don't like this try again yeaji
meanwhile
saw goldman as a business partner and
the head of AI G's financial products
unit the unit that had entered into the
CVS with Goldman Sachs makes repeated
references to the fact that hey no we do
a lot of business with Goldman Sachs and
we don't want to just tell them to go
away we want this relationship to
continue and press this to his
subordinates that they needed to manage
this relationship with Goldman Sachs
Fritz part Goldman Sachs also thought
that enforcing these collateral
requirements could be embarrassing for
the firm why once you enforce them this
information leaks out into the
marketplace and exposes one of two
things if not both the first is that
somebody thinks that you don't know what
you're doing in terms of the valuation
of the underlying CDOs
which to a firm like Goldman Sachs has
clear reputational implications as a
market leader the second thing is that
rule number one at Goldman is that the
client always comes first bankrupting
your client because you wanted to get
your collateral back sort of chase set
that notion in a very sort of obvious
way and so we see one of the senior
Goldman Sachs structured products guys
writing a memo to the Board of Directors
saying look we want to be really careful
with how you communicate this to both
AIG but how you communicate any details
about this dispute to the marketplace
because any details that make it out can
only say bad things about Goldman Sachs
of the firm
lastly we see yeah I'm sorry love I
don't know whether this is a and
alternative hypothesis or is part of
what you're saying but when you're
dealing with a solvency bank like this
then managing the future relationship
seems the counterparty is going belly-up
so so in part of Goldman's strategy here
at this time period was its relationship
with the government and using the
government in some sense to be the
counterparty so when AIG says Goldman is
a business partner needs to manage the
relationship that makes complete sense
you are coming to take you but we
dollars missing oh gosh we need to match
situation yeah but nothing you know just
if not for anything just so that they
don't go belly-up sooner than they like
you and Bolin's perspective it might
just simply be a case of saying well
we've got actually a much smoother way
to to collect all this right and so it's
not really managing the future
relationship as much as I need to make
sure that there are some suckers in the
market to divide the crap that we're
selling and and so is that the same
story is it in different stores so and I
completely agree with there's several
added elements to this that make it
strange
well not strange entirely predictable
and make for a messy signal and messy
relational story here right so as I'll
talk about a minute Goldman Sachs also
started taking out CBS on AIG so it was
actively trying to mitigate its
counterparty credit risk AIG or what in
effect at that point was the risk that
the collateral would ever be delivered I
think this story is also consistent with
the idea that they were trying to milk
AIG for as much of the collateral as
they could before they let it fail right
because they knew that AIG had a
liquidity constraint and the longer that
as long as it kept the its foot on their
throat it could let AIG sort of
liquidate as much collateral as it could
because of the car boats
the automatic stay in fraudulent
preference rules it could theoretically
extract more from what is about to be an
insolvent estate and it is also
consistent although I think my personal
view and I know it evidences for this my
personal view is that it probably wasn't
golden Sachs strategy Oh Angie will get
bailed out and will get the print
benefits of that bailout which is
ultimately what happened but it's
consistent with that story as well
absolutely so yeah and what I also want
to take away from this is not the pure
relational story that our relationships
great but that this story is actually
idiosyncratic to this particular
relationship and that because this is
idiosyncratic it could be the syncretic
in another case and in fact AIG was also
entering into parallel negotiations with
Societe Generale at the same time that
went along entirely different dynamics
why because sock Jen was not Goldman
Sachs the exposures were significantly
smaller and sock Jen had taken the sort
of not on unreasonable position that was
going to wait to see what golden Sachs
did before settling anything
hesitation
of course there fail and say and what
can we learn what we generalize from
from a policy perspective or just in
terms of describing the well I think so
again we actually get on to now because
I don't think that the stories are
consistent because if Goldman Sachs
treated Catholic wakes with government
bailout they have to appear as a pretty
harsh man towards push the AIG brink if
it's all the same work to make it
credible but they're happy prevail
because government realizes well these
guys aren't so tough line on this for
anyway so they might method ways that I
think there is I mean your intention of
his stories was a dissonance that are
there right so I'm talking about the
relationship between Angie Bolen Sachs
the executives in a room talking as such
women documented by both Ben Cohen book
and then the FCIC material goldman sachs
was very good at making sure that it
sent its collateral call every day right
from a formal legal perspective it was
lining up the future litigation
perfectly every day new collateral call
updated on their current marks that then
made them look tough right they didn't
so the the formal documentation that you
would ultimately expect to be submitted
in court was definitely the tough stain
what made it interesting was I got
accent well we all have access
Thank You SCIC to this other
conversation that was going on and we
also don't see right that these
statements were made internally at
goldman sachs and internally at AIG you
know I wouldn't let my mother read some
of the correspondence between AIG and
Goldman Sachs that was much more
unsavory I suppose but I Ruth her point
that I think that there is that tension
there in that element of the story for
sure did you oh yeah we were gonna go
ahead to this so and I'm just gonna put
a pin in it for one second so we can get
through there just to say that
so what a relationships
we do here well one in a world where
contracts are incomplete they can give
us some flexibility I've put this sort
of three different ways you can have
flexibility this can be a safety valve
against contractual rigidity
if AIG had to post collateral within 48
hours it would have failed a year
earlier is that a good thing or a bad
thing I'm not making any judgments there
or alternatively from a more finance
perspective what the flexibility does is
provide one party with optionality
effectively to not adhere to strict
enforcement of the contract and that can
have pretty valuable benefits
I've also for those that enjoy sort of
the more legal elements of contracting
made a couple of points here that things
like valuation agents can be useful in
so far as to give the parties an
opportunity to signal that they're being
cooperative or not cooperative in the
context of relationship enabling the
parties to learn about what type the
other counterparty is cooperative or not
cooperative and it's sort of consistent
with the braiding hypothesis of Gilson
sable and Scott that if we know that
contractual rigidity can bind our hands
when we enter into these contracts it
may be useful to also have these escape
valves in the contract that then say
okay well when things are really bad
reputation strains will enable us to
inject some flexibility into this
contract but back to the question so
John's question about what's
generalizable here and let me know if
you think that I'm not answering this
question I think the first thing is that
this case study shows as you'd expect
from reputational mechanisms that the
bigger the relationship the more
flexibility you are likely to see when
everything hits the fan so if you are a
small counterparty with goldman sachs
you're unlikely to see that flexibility
and certainly as a you know somebody who
comes from the asset management side of
things and would do deals with goldman
sachs i never saw any of this
flexibility if you objected to anything
in is the Master Agreement that didn't
return your calls for three months and
everybody was breathing down your neck
so the AIG story is not one
I necessarily saw when I was on the
other side of the table so the size of
the relationship could be important in
this in terms of general things to take
away may complicate the matter more than
simplify it is that in derivatives
markets there's a lot of mechanisms that
then create countervailing incentives so
this relational world doesn't or is
going to be less important the more the
counterparties are collateralized or in
the case of Goldman Sachs
where one of the counterparties has
taken out insurance against the failure
of the other counterparty in those
worlds where the loss experienced by one
counterparty as a result of the failure
of the other is going to be lessened we
would also expect relational less
mechanisms to play less of a role it was
also important here that there can be
cross purposes I think this is one of
the more important elements of this so
if the relationship was what was making
Goldman Sachs and AIG negotiate Goldman
Sachs was also up against the fact that
it had relationships with other
counterparties with other market
participants that it wanted to take into
consideration as well so we see a IG
very early on say let's go to a dealer
pool and then for the next year Goldman
Sachs basically resists that even though
it's in the contract it's like we don't
want to go to a dealer pool why well the
internal correspondence makes it clear
we don't want to go into the marketplace
and say Goldman Sachs does not know how
to value these assets
please help that sends a negative signal
damages the reputation of Goldman Sachs
in the marketplace and so understandably
they spent quite a lot of time resisting
that so in effect their relationship
with AIG in a bilateral context had an
additional degree of in flexibility
because Goldman Sachs was worried about
its relationships with other
counterparties other market participants
the last thing is and this sort of
stands to reason or so where the last
things is understand see reason
is that when the parties don't have
equal standing the relational aspects
may not prevent opportunism or an AI G's
case may not prevent them from biting
off their nose to spite their face as it
turns out Goldman Sachs had pretty
robust methodologies for valuing the
nisi
so even if there wasn't a market price
they had a defensible way of putting a
value on these things
Angie objected to that but in
congressional testimony it ultimately
came clear that franca Sano never even
attempted to come up with a valuation
model for these CEOs
so given Goldman Sachs's role as a
market making dealer given its at least
attempt to value these assets any
negotiation over their value against a
counterparty who either didn't have the
expertise or inclination to do so was
likely not to be one of pur arm's length
negotiation where the relational
mechanisms enabled the parties to avoid
situations where one took advantage of
the other uh and lastly and again I
think this is fairly straightforward
once it became clear well once it became
relatively clear that one of the parties
was going bankrupt or may go bankrupt
subject to this specter of state support
relational mechanisms go out the window
you know a lot of Karelian
subcontractors are learning this lesson
as we speak right now right all of the
attempts since last October I guess are
even further in order to save the firm
mean nothing once you've got your
compulsory liquidation except of course
when the government intervenes to bail
you out so I don't know if that answers
your question John in the sense of
what's generalizable I kind of see the
the top-level generalization being that
there are no generalizations and then
the second level I guess gives you some
predictors of when you'd expect to see
relations dominate so when the numbers
are big so when you could lose a lot of
money relative to a small amount of
money when things like collateral have
not been provided thereby exposing
counterparties to the full sort of
exposure to losses where we don't see
these cross-cutting mechanisms like the
dealer pole and where we don't see these
asymmetries of information in bargaining
power and so there's a come to it there
we are actually so what I'd expect to
see is and I make no representation
about the accuracy of this arc but the
shape is supposed to sing that
the idea that when there's no changes or
changes are observable most of the time
the contract can do all the work we just
look at the world we look at the
contract says we're supposed to do in
that world and we execute it we have a
property right system and a contract
enforcement system in the background
that enables us to affect those changes
but this is contract as blueprint as
instruction manual for how the
relationship is supposed to work as
things get more complex as things to get
less observable we would see some sort
of increase into the relational world
that is to say it may not be big it may
be very small and incremental where we
work out on a relational basis what we
want the contract to do going forward
and that to a certain point will get
bigger and bigger as the problems get
bigger and bigger but then as we start
to think about insolvency and we start
to think that this relationship may not
have a future
we should see this drop rather
dramatically and again I'm not saying
anything about the shape of this
particular curve just the general
direction of travel that we might see in
these markets now you worked on the
basis of the assumption that there is
advance occur
I am okay now how would this push change
where there no problem well so I I think
that's a really interesting question I
think what we would have is well I
suppose try to think about how how we
want to consider it in shape I think
we'd probably see this the last part of
the curve moved farther to the left
right just recognizing the fact that all
of a sudden bankruptcy becomes a strict
failure
so you and knowing that you'd probably
see a lower slope of the curve on the
left-hand side because you wouldn't be
willing to take as much risk as much
exposure to the firm so assuming this is
accurate for a second I would think that
you would just shift it farther to the
left and reduce the slope of the
left-hand side of the curve so they
would make less relational investment
ex-ante and they'd be sooner in pulling
that relationship back in when the
specter of insolvency started to rear
its head would be my first intuition on
that
all right so what does all of this mean
and I'm I want to open this up for
discussion if for no other reason than I
can eat my sandwich the paper goes into
more detail about this one of the horses
I've been beating for a very long time
is that derivatives should not be
treated as securities the paradigm of
market our information forcing
regulation to force market transparency
well perfectly consistent with the idea
of deep liquid markets in good times is
really inconsistent with the other half
of this story where all of a sudden I've
got debt contracts that include elements
of property and relationships
this looks like a commercial loan that's
been collateralized not like a publicly
traded share or a bond and this is more
than simply a categorical issue right
the last time that we allowed a
securities regulator oversight of a
Prudential issue was the consolidated
supervised entities program of the SEC
labeling the SEC to oversee the capital
calculations of the major investment
banks that was an unmitigated disaster
and understandably so their market
regulators their objective is to force
information and enable the market to
make decisions about things Prudential
Regulation the regulation of loans
counterparty credit risk is all about
private information that is analyzed and
then decisions are made by Prudential
regulators about how to manage that risk
two completely different paradigms and
one that then means that we can't get
caught up in the institutional path
dependency of banks do banking
securities our markets most modern
financial systems are hybrids and
derivatives in that respect are just an
example of this the other three policy
implications that I talked about in the
paper all come down to this question of
whether the flexibility injected by the
relational mechanisms is a good thing or
a bad thing
and for those who read the paper you'll
see that my answer is both depending on
what stage of the relationship were
actually at so in terms of central
clearing central clearing basically
takes out the relation elements right so
we have entirely standardized contracts
we have automated rules about the
collection of collateral so for example
but for a couple of mechanisms I'll talk
about in a second
a Clearing House doesn't have the
ability to say okay
gee you look like you're going to fail
so I'm not going to collect collateral
from you today I can't do that the rules
have bound their hands to a system where
you see both a high degree of credible
commitment because the rules are so
binding but also potential contractual
rigidity one of the things that's not
appreciated entirely about these
clearinghouses is that there are
mechanisms designed to alleviate this
contractual rigidity and the two that I
talked about in the paper are things
called partial or complete terrip
procedures which is the name implies
enables you to tear up contracts and
then variation margin haircut gains
which effectively enable you to accept
collateral from counterparties that are
on the money but not pass it on to the
counterparties there in the money
thereby enabling you is the Clearing
House to fortify your own balance sheet
in the middle of market distress now
that in turn raises some questions about
the governance of clearing houses and
who you want to have control over this
flexibility and I talked a little bit
about in the paper but isn't fully
developed right now who you want
controlling those decisions depends on
the governance model of the Clearing
House so is it owned by members or is it
owned by another sort of independent
firm like a stock exchange or
independent third party investors if the
former well then you have one set of
incentives when it comes to exercising
these mechanisms if the latter and there
are sort of third parties and detached
from this one might think that their
incentive is actually to download as
much risk as possible onto the clearing
members in which case there may be
conflicts of interest between the
survival of clearing members and the
survival of the Clearing House and in
that case it may be useful then to
allocate that discretion to potential
supervisors as opposed to the Clearing
House itself I it wouldn't be a paper
these days if it didn't have some
blockchain component to it it probably
doesn't surprise you to know that the
International Swaps and Derivatives
Association has doubled down on using
distributed ledger technology to even
further automate clearing and settlement
within derivatives markets and again
this makes a lot of sense given the
state contingent nature of the lot of a
lot of the contract features but also
presents
potential contractual rigidity that is
to say that if I have these systems
where I automate in effect things like
variation margin requirements things
like variation margin haircut gains that
if those rules aren't complete if they
don't entirely automate every potential
response to every future state of the
world we may end up in states where we
end up with what's called wrong-way risk
where we end up enforcing things like
collateral requirements in ways that
undermine the integrity of his system so
they cause a clearing member to fail and
the reallocation of losses among
surviving clearing members cause the
Clearing House to fail which then has
feedback effects to the surviving
clearing members this has happened in
the past and could happen again again
the key then is coming up with similar
mechanisms safety valves that are
designed then to alleviate the pressures
of contractual rigidity in those
circumstances and there's a couple of
computer scientists at Cornell who have
developed a protocol for permission
distributed ledger system that then says
basically okay we can press the stop
button no transactions go through but we
crystallize at that moment in time what
the obligations are and then when
whatever crisis has passed when we have
more information we have two choices we
can press play in which case the
performance at that given moment in time
is then executed or we can amend
performance given new information that
we now have in the marketplace so we
inject some judgments and human judgment
back into what would otherwise be an
entirely automated system lastly and I
think I'll just mention this very
briefly we don't have a great conceptual
basis at this point for understanding
why we do things like support markets
during periods of market turmoil so that
was you know thirteen or fourteen
different initiatives that the Federal
Reserve in the United States took to
support markets during the financial
crisis not financial institutions but to
support very specific markets they asked
that commercial paper market the ABS
market derivatives markets I and I think
understanding these these contracts as
having a relational element that then if
it works during good times breaks down
during bad times gives us a sense of
what the wrote state's role is in that
circumstance where the trust breaks down
the role of the state then as the
counterparty that can't default is to
stand behind contracts put in a market
floor that raises a lot of interesting
institutional questions about how you do
that without creating moral hazard
without having people gaming the system
but it at least provides a theoretical
basis for understanding what the problem
is and then providing some sort of
justification for failure unless the
insurance concerned you can have to give
it all back again it wasn't a matter of
going this money so that we keep it they
were saying we want this money as worms
against you're not paying claims in the
future
and in calling that collateral will
cause the collapse of the insurance
company then you were disastrous
position because you had the money you
lost the benefit of
times worse so ideas very useful
demonstration of the value as soon as
you get into the weird world collapses
you have to stop you know thinking in a
very different way from the way that you
think about payments and in the context
of credit derivatives particularly yeah
I think that's right I think those that
in the case of AIG there's also the
basic financial economics of insurance
that comes into it where a AG was
underwriting the insurance of a large
part of its markets and if insurance had
to be paid out for these events it was
going to be highly correlated in which
case the insurance company fails which
is just sort of a vindication of the
idea that you can't insure against
systemic risk which came out of space I
should say there's a paper a great paper
in the Harvard Law Review by Richard
Squire at Florida who says that AIG
understood this perfectly and was
actually on the other side of this
market in the securities lending market
as well because it knew that if it you
know either heads I win or tails you
lose if the market survives I make money
on both sides of the table if the market
fails I'm done anyway
and it's somebody else's problem if you
can't get your pass from me tough luck
so that the I'm dead you're dead
scenario so yeah I think it's a I sort
of the intermediate and higher levels
this is exactly to look at yeah
it's a full well I think that the way
you frame the problems case study I
think that somehow whose is the systemic
dimension which i think is at play here
because most of the incentives
relational or not probably almost
motivated by the idea that like I said
this is going to do it anyway somehow
your partner it is something that that
beyond the sheer size of the contractual
relations markets I agree it bugged me
about that case study as well you know
this idea sort of sat for a really long
time until I came across the FCIC
material but I think to fully deal with
the implications I need more material
and what market participants were
actually doing and thinking at that time
the problem is coming up with some sort
of toehold
to be able to say that I think exactly
that there is a savage dimension of
systemic instability and of course then
that would enable me to be much more
robust in my discussion down here of
what the dynamics actually are in that
context
in case of a department that in case the
counterparty goes bankrupt those
informal
Gobbo need to extend reputation still
and so fascinating question right so I'm
the administrator of a banker's
if Arg and gone bankrupt and it looks at
what a financial institution is right
it's its reputation charter value is
everything in financial services so if I
just liquidate in effect or if I start
cherry-picking contracts that I've been
callin her versus those that I'm not
going to in bankruptcy that can have a
knock-on impact in terms of the
viability and value of the entity that
reads bankruptcy subsequently now that's
complicated by a few things right how
much is firm reputation with invidual
reputation but I think you're absolutely
right that there there's reason to
believe and especially for financial
services firms if any anything where the
assets are primarily intangible there
will be something that survives
bankruptcy in the relational sense in
fact that may be another bankruptcy
scholars in the room there may be
something that I could talk to them
about because which is also I mean
immediately I shouldn't do it for the
precise reasons that you've mentioned
but that's part of why this isn't a
straight line right because if the
relational story died at bankruptcy then
I would just have a point here that was
bankruptcy and then it went straight to
the horizontal axis so yeah now actually
the reason for drawing
and bombs and for sure
the in terms of contractual relationship
I think the difference there would be
that that story requires on a
specialized intermediary acquiring the
bonds right so the the the parts of it
that make it look similar are then
because a specific injury the area
requires a specific acquires a threshing
around to the specific type of claim if
I understand you as opposed to the the
instrument itself does that answer
Russian yeah it's not every people to
provide a threat know that that the
tragedies they would there be be
instruments to deal with that
uncertainty and the promise of having
that so anything like long agents or
collective action positive things like
that and the fact that there's a market
where these interests and be aggregated
and you can't negotiate so I mean my
starting points for that is that you
can't negotiate the terms of all what in
the secondary market right it is what it
is you can create derivatives that then
divide to that but you've just created
derivative to do that whereas
derivatives because these are executor
effect contracts right because we've
actually got an individual counterparty
who may have entirely uncorrelated
payoff patterns to the actual underlying
that creates the difference here so
there's an idiosyncratic nature to it
that just I can't see existing in a more
commoditized product so if I want so the
the longer answer is so if if the
alternative version whose rights and
that bonds are derivatives and rivers or
ponds why would I have a derivative
right and putting aside that maybe my
bond market is incredibly illiquid
now the idea that their economic
equivalents and their knowledge and I
know this because I can intentionally
derivative on a bond that gives me a
very different portfolio of risks
primarily contrary creditors which
doesn't exist in the Bowman even though
my payment structure under derivative
can be identical in terms of just
linking it to the current market price
of the bond and recreating the cash
flows associated with any to lawmakers
so I'm freed a new risk by using
derivatives there and that new risk
can't predict this in most states in the
world ideally should be uncorrelated and
if that uncorrelated company credit risk
because I find to be a different thing
and it just so happens that 95% of the
contract is dedicated to what do we do
with that uncorrelated champ right
cutter is does that make sense
have any sufficient similarity which you
can either go to bankruptcy or not so he
was the issue with their reservation
that of minutes the same save that for a
marketable security are unlikely to have
unilateral power of renegotiation and
because we don't have the unilateral
power to renegotiate any relation
mechanism will be lessened it's because
your relationship is necessarily less
important another way to put this in
which case I'm totally agree because as
you get more concentrated holdings in
any security there's likely to be more
relational mechanisms you know that's
sort of let's acknowledge you corporate
finance literature and acknowledged in
the rules around things like controlling
shareholder laws and that I'm totally
agree with but it and it's on a spectrum
right so a derivative contract gives you
that from day one because it's a
bilateral contract between you
completely analyzed two Spurs markets
where I'm a price taker if I was a price
taker in the market I'm probably a price
taker in any renegotiation as I gain
more control though I can use that
control for the purpose of influencing
outside of the balance of the contract
that is relationally on the issuer of
those securities not I totally agree
with that
it's a very nice boy I think the first
question becomes identifying which
markets you actually want to support and
to me the first answer to that question
is the interest rate swap are you
different swap market is largely
dictated by macroeconomic policy issues
around short-term versus long-term
interest rates and expectations of
productivity and growth that's exactly
what central bank macroeconomics
departments do for a living
aside from that guess who the primary
players are on that market already it's
the government right open market
operations are entirely affect
understanding your employment pricing
within those markets so that lends up
fairly well but that's the easy case
from there it's really easy to talk at
the same time from there we have to sort
of well what are the other markets we
want to really support I mean really
support do we want to be an esoteric
commodity futures markets may not so we
want to be in equity derivatives markets
probably not do we want to be in single
ABCDs markets probably not both because
absent other factors they shouldn't be
systemic important but also can I agree
with you that we wouldn't expect the
states to have any additional expertise
over the markets within those markets
now the interesting one that leaves is
actually the foreign exchange market and
I can't get my head around this one both
because you know miss will talk about
the deepest marketing world right there
more transactions and
exchange market per day then well every
20 days before exchange market does more
volume than all of the world equity
markets in the year it has never
experienced the type of fundamentally
liquidity that would experience in the
financial crisis spreads widen quite a
bit but we haven't had the experience
yet where market making dealers actually
believe so that you can't get a price
now that's not to say it can't happen
because it can but I think the it's a
special case today philosophies firstly
because money and FX is the most
information in sense for the asset you
could possibly imagine
so it's not like market participants to
look at the government to the United
States and say I know where the US
dollars gonna be in five years I mean
lots of people think of good living and
trying to do that but it's difficult to
come up with rationale for why they be a
better doing it than the government
themselves so the short answer to my
long answer interest rate swap markets I
think that both of the incentives and
expertise land up quite well a lot of
other derivatives markets so especially
equity CBS and quantity future markets
not systemically important I probably
wouldn't advocate them intervening and
the one I've got to think about is FX
markets right they're big they're
important but historically we haven't
seen them break down in the same way
that we've seen others right now maybe
we could hide
question I think I just want to research
earlier actually you've got like but
they're also very separate things do you
have any idea that how there's
relational making it play out
was it the first hole is based on the
attacker in the online everything the
making of the Atlanta so that's that's a
market where it is which were then lead
to credit podraces but they always kind
of inspire is some kind of intuition I
have been lobbying the Office of
Financial Research in the United States
and the Bank English in the UK to start
collecting that data for quite a long
time I can't stress enough how the FDIC
sort of report on this one contract
represents what academics know about
what these triggers look like the
interaction sponsored Association has
definitely said to market participants
look these posts difficult records to
get them out of your contracts but we
don't have anything that tells us
whether they've been removed and
you know a beautiful research question
maybe one day the Bank of England roll
the seeds by request and we'll be able
to look at the evolution of the market
if there has been so but it's a
different spectrum right so if I can
turn to during the contract with horses
and I interviewed you for contract with
goldman sachs chances are the relational
dynamic between a horse tonight will be
bigger but you'll always be different
because tokens accent different kind of
horse bargaining but in a bond market
both horse dry or woman sex if we went
out and bought enough of the bonds could
exert relational sort of dynamics on
this situation so it's and that's the
difference right in derivatives it's
about the security or the instrument the
instrument confers possibilities or
relationships in the case of bonds and
shares it's about who holds it which is
a different thing also the fact that
there's no depth in their rights are in
a sense that I've got the deck but in
the in the sense that if I just hold a
whole bunch of bonds I have credit risk
the other side of my right all there is
is darkness and the threat that I might
sell or say that everybody else should
sell or something like that
there's no reciprocal exposure that
brings the two of them together whatever
there's no natural reason why they
should have a relationship unlike a
derivative where the existence of the
contract is the reason to be is but I
mean this is not you know this is not a
clean answer so this question at all and
I think that it's you know I've been
working on this question probably for
about five years now this is my second
or third paper on it and these
objections are still degenerate
objections to this issue so we're still
drilling it down I still think that
there's there's something there there's
a new section of paper that I'm not sure
it isn't the one that I've circulated
that attempts to distill this more
cleanly but it does so on the basis of
if I'm holding it what is it to me right
and if I'm just holding a bond so we
take the smallest unit of the poem and
the smallest unit of derivative and it
seems to me that there is no idea what
the smallest unit is right but a
contract and a bond is that that bond is
gonna have no relation of elements to it
how do I know this I can toss it to
somebody else who's gonna pay for it
right the smallest amount of the
derivative contract
I just can't punt it to somebody else I
have to punch to somebody else who's
willing to take the counterparty credit
risk it using traffic risk of my partner
party
so it's incomplete risk transfer in
economic terms and in practical terms I
don't sell it and then forget about it
myself and continue to have to worry
about it because I still have the
original risk and I've just created a
new contract also with market risk but
not the kind of pretty credit risk
associated over that contract I am
that's the basis whether it works or
relational
whether a relational dynamic is the best
way to characterize that is I can even
have a question for me and I'm the one
it's like you I think it's time for
close of nothing about this contract out
and there's an in the money there's a
net payment and I think that I we owe to
you thank you very much for showing us
