This doesn\’t quite make sense

I don\’t know whether it\’s the journo not making it clear or something deeper and more disturbing that is wrong here:

The EU has moved to pass a directive, the Emir, or European Market Infrastructure Regulation, to regulate the trading of complicated financial instruments that many blamed for causing the global financial crisis. The legislation aims to standardise all derivatives products not traded on a regulated exchange.

The point of having derivatives that are not traded on an exchange is to have derivatives that are not standardised.

Think about it for a minute: so, imagine, you want to play about with 3 month, 6 month aviation fuel prices. You\’re an airline, you\’re taking money from people now for flights that aren\’t going to happen for another 5 months. You need to hedge your exposure to possible changes in fuel prices: don\’t forget, you\’re charging people a fixed price now and you\’ve a variable fuel cost in the future.

I\’m pretty sure there are aviation fuel futures (and or options?) over in the US but even without those you can get a pretty good synthetic cover by playing around with crude oil futures and options. The link between oil prices and aviation fuel prices is pretty direct: the refining margins tend not to move around very much.

Excellent, there are deep and liquid exchange traded futures and options so off you go and hedge your exposure. In exchange traded products.

As just such an airline you\’ll also probably have a little flutter on currencies as well: you\’re collecting money (as a European airline, say, Ryanjet) in euro and pounds, maybe a little in Danish Krone, Czech Crowns and so on. But aviation fuel is (normally) priced in $ so you want cover there as well.

Deep and liquid exchange traded markets here as well.

So, why would you want an OTC derivative?

Well, let\’s say that these exchange traded products only extend out to 9 months (don\’t know whether that is still true but it used to be, for both options and futures). But you\’re buying planes on 20 year leases: perhaps also you\’ve got some worried about what fuel prices are going to be in 3 or 5 years time. You are, recall, making 20 year bets with your aricraft leases.

You probably don\’t want to be playing with futures here (a future insists that you trade at the relevant time at the agreed price) but options will do very nicely (an option allows you to trade at the agreed price at the relevant time). It\’s an insurance policy really: you work out what $/€ rate will bankrupt you on your lease payments, work out what aviation fuel cost will bankrupt you, shave a little bit off those prices then purchase options. So, if either price moves to where it will bankrupt you you can exercise the option and just about stay in business, getting your $ or your fuel at a price that allows you to do so.

Options out 3 or 5 years can be expensive, which is why you set your option price at the most extreme price that allows you to stay in business: rather than paying a higher premium that will ensure profit but that higher price might unacceptably bite into current profits.

(Umm, do please note that all of this is made up, it\’s an example. An example of the logic, not a precise description of what airlines actually do: that I\’m not privy to. The basic effects are right, if not the precise actions.)

But there are no exchange traded products which go out to 3 or 5 years. If you are limited to exchange traded products then you can\’t actually hedge your risks. Thus you go to Mr. Global Megacorp Bank and make up an OTC option which will cover you.

It might well be that their bright young things will then go and hedge this option in the exchange traded markets, using a mixture of shorter dated exchange traded options to cover their longer term risk but you as an airline don\’t care about that. You\’re covered which means you can get on with working out how to charge people for having a pee while airborne.

And that\’s why OTC markets exist: because there are people out there who need hedges which can\’t be done with the standardised products on the exchanges. Which means that the desire to standardise OTC products is doomed to failure: the whole point of them is that they are not standardised.

As I said at the beginning, I\’m not sure whether it\’s just the journo who has made a casual error here or whether the EU really is trying to do this impossible and highly undesirable thing.

Neither, frankly, would surprise me.


5 thoughts on “This doesn\’t quite make sense”

  1. Most of the OTC derivatives trading is in fixed income. Banks borrow short term, but lend long-term and they need to hedge that risk. It’s the CDS that are blamed for bringing down the financial system (by far not the only fixed income derivative with counterparty risk). The politicians and regulators who set the rules that create barriers to entry so high that insider firms grow unnaturally large and begin to take unnaturally high risks on the assumption that they will be bailed out is not at all a problem, of course. Obviously, we need more of that.

    The regulator can’t understand derivatives. It certainly can’t begin to wrap its mind around understand structured products.

    It’ll be interesting to see what they do about CDS as the regulators’ understanding of plain vanilla equity options is shaky at best and CDS are teeny options which are extraordinarily difficult for even the smartest options trader to price.

    The net effect of standardizing all derivatives is to make lending and running a business more risky, more expensive. The drag it will create for the economy will be “unseen”, with all increases in prices and lack of investment blamed on greed and the failure of capitalism. Meanwhile, the regulator will bask in the glory of its role of benevolent protector.

    It’s a great system we have here.

  2. As I understand it the main thrust of ‘standardisation’ is in practical things like legal and contractual terms, accounting, etc.

  3. As I understand it, it’s not to make them standard. It’s to make them reported.

    Currently, exchanged-traded derivaties are reported because they are on the exchange, whereas OTC are completely private.

    Once all are reported, it will be easier to impose a financial transactions tax.

  4. My understanding is that they’re standardising them so that they will be easier to migrate to either existing exchanges, or maybe a new more flexible super-exchange. At the very least, a network of clearing houses with transparency rules. The capital buffer treatment for the residual OTC non-exchange traded derivatives will then become much more penal than for exchange-traded.

    The bit that George just supposedly fought off was the EU tried to insist that all such transactions denominated in Euro must be with a clearing house located in the eurozone, thereby shutting the City out.

    Of course, all this nonsense just means the next big financial crisis will be Clearing House liquidity/solvency, as that’s where we’re now concentrating all the risk.

  5. Strange. There was I, as a layman, thinking the crisis was caused by too much debt – individual, business and sovereign.

    Constructing derivatives based on dodgy debt may be unwise, but they’re not the fundamental problem, surely?

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