September 2012
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Born v. Greenspan

PBS Frontline has produced a show, The Warning which documents the CFTC’s attempt to introduce regulation to avoid a financial crisis brought about by the derivatives market. It cronicles how the three marketeers, Greenspan, Summers, and Rubin successfully shut Born down because the light she attempted to shed on this dark market threatened the solvency of the players (big banks). They also dogmatically believed, as I do, that the markets would self-regulate. At the end of the documentary, Greenspan admits (before congress) that he was mistaken. Since I’m not fan of government regulation, I’d like to ponder what’s needed for self-regulation to be successful.

First, I think self-regulation requires that market participants are risk-adverse. That is, bettors should not want to go bankrupt. If they are both informed and rational, when given a choice between two bets with the same expected yield, they should want to choose the one which carries lower risk. They should also not be too greedy, chasing after high returns into territories of high risk assests. I think the enforcement and threat of bankruptcy should ensure risk aversion. That is: no bailouts and no mechanism (ex: FDIC deposits) to offload the risk onto taxpayers.

Second, I think self-regulation requires informed participants. Participants may not always act rationally, but the less information available, the more the financial models, assesments of risk and return will be mistaken.

Third, I think the market needs transparency. An insurance firm can only price credit default swaps if it can accurately measure the probability of default. That measurement requires an in-depth assessment of a firm’s portfolio. Without a model of the network of financial dependencies, it’s not possible to simulate a firm’s ability to pay when the conditions of the contract are met. It should be possible to track a circular chain of insurance (liabilities) so that the events would which trigger a financial cascade failure can be identified.

Under Greenspan’s watch, the derivatives market lacked transparency, so it was unable to self-regulate. Instead, market participants chased high return assests into unknown, but high risk, territority. The high returns appeared stable because the financial models don’t track two or three levels in the financial dependency graph, so they assessed much lower risk than actually exists. The participants were unwilling to introduce more transparency, because they thought that by placing bets which largely cancel out (arbitrarging return while transferring risk) they could avoid risk entirely. However they unsafely assumed no counter-party risk on these trades.

Is it up to the government to step in and force the transparency? I’m not so certain. Perhaps a different exchange, which ensures transparency can be made attractive enough that players switch to a different arena.

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