The Derivative Conundrum

     Author: Jim Sinclair

I have constructed the following open letter to Chairman Greenspan.

Dear Chairman Greenspan:

Understanding the mechanics of over-the-counter derivatives is a unique talent. In order to fully grasp what the OTC derivative risk is all about, experience as an owner and risk taker of an arbitrage company is the best prerequisite. Because of this, even a member of the Federal Reserve Board cannot be expected to have all the facts at hand.

Your recent expression of concern over the growth of what you refer to as the “derivative market” is well placed even though you restricted your commentary to a certain group of OTC derivatives and renewed your opinion that NO regulation of these specific performance financial vehicles is required.

You refer to the OTC derivative market which is a significant stretch for the word “market.” I can with authority and experience state that this market is not simply illiquid it simply does not exist.

As a result, there is no one standing ready as a market maker to produce bids and offers as is common to the basic structure of an active equity market. There is not even a computer system linking traders able to match bids and offers.

The non existence of the OTC derivative market is a direct result of the fact that there is no standard form of OTC derivative contracts on more than 95% of the OTC derivatives outstanding. Without standardization, such a December gold contract on the Comex, whereby maturation and specifics of delivery are specified and common, no market can exist.

Your expressed fear is that a mass exit from a certain generic type of OTC derivative could cause a problem is not in a practical sense correct. This is because there is no exit door at all. These instruments are made or unmade by negotiations with an entity that offers its services to so do. In order to close a commitment, an entity holding that commitment must have an entity calling itself a derivative dealer find some fool to take the other side. The chances of that happening in a mass exit situation are non existent unless the holder is willing to take a terrific loss because it will not appear in a fall until the bottom or in a rise until the top. Expressed differently, if an entity is in danger of bankruptcy in OTC derivatives, it is going to experience bankruptcy because there is no exit door.

Regarding the opinion that there is no need for regulation, you might consider the following:

1. OTC derivatives are not transparent.
2. SEC reporting requirements do nothing to provide for transparency of derivatives held by reporting companies.
3. Exchange reporting requirements do nothing to provide for transparency of OTC derivatives held by member companies.
4. OTC derivatives are not listed on any major exchange.
5. OTC derivatives are akin to special performance contracts unfunded and floating within the system as special performance financial obligations which are totally dependent on the balance sheet and liquidity of the party to the agreement that is the loser. This is a fact because unlike the listed derivatives called futures and options there is no clearinghouse guarantee for the performance of the obligation. That means that there is no true accounting or payment by the loser to the winner on any time basis via a clearinghouse. Therefore, the loss builds up to a crescendo until the only option is a complete bailout or bankruptcy.
6. Because there is no open market for these items, evaluation of OTC derivatives is simply a computer calculation made using assumptions of conditions prevailing at an assumed future period. To make these assumptions correctly is quite rare and in fact is almost  non existent. If you had that knowledge you would be recruited by the Federal Reserve and in time have the honor of being a governor unless you preferred simply to corner the world’s supply of money.
7. The majority of entities doing the largest business in OTC derivatives are subsidiaries whose parent is usually a well known and internationally respected investment firm or bank. There is no requirement under law for such a parent to guarantee the subsidiary as it pertains to trade debts. There is no way to know the financial condition of these subsidiaries or the degree to which they have extended themselves on these instruments. The reason for that is that these subsidiaries are primarily domiciled in areas where capital requirements for these transactions do not exist..

The following data was reported by the Bank for International Settlements in its 2004 review of derivative activity:

OTC derivatives market activity

Turnover data

Global daily turnover in foreign exchange and interest rate derivatives contracts, including traditional instruments such as outright forwards and foreign exchange swaps, rose by an estimated 74%, to $2.4 trillion, between April 2001 and April 2004. At constant exchange rates the increase is 51%, still considerably higher than the 10% growth recorded in the previous survey.

Daily activity grew in both OTC segments, ie interest rate and currency-related derivatives, up by 110% and 51% to $1,025 billion and $1,292 billion respectively. Over the same period activity in exchange-traded derivatives rose by 114%, to $4.7 trillion. Given that exchange-traded derivatives are composed, for the vast majority, of interest rate related products, the expansion recorded in the two markets, OTC and exchanges, has been comparable.

The growth of business in exchange rate derivatives parallels the 57% expansion in turnover in traditional foreign exchange markets. Higher demand in both the traditional and derivatives segments reflects the greater role of such products as an alternative investment class to equity and fixed income products, as well as the larger role of hedge funds and asset managers. In the interest rate segment, changes in hedging and trading practices in the US market helped boost activity. Business in interest rate derivatives may also have been favoured by an exceptional rise in volatility, especially in the US market.

Trading increased at especially high rates between reporting banks and other financial institutions, mainly hedge funds and insurance companies. Expansion was also strong for activity with non-financial customers, ie firms. London and New York remain the two largest marketplaces.

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Conclusion

Therefore I offer the conclusion that OTC derivatives - not exchange listed derivatives with clearing house guarantees - are the greatest risk to the US economy, the world economy, and the US dollar.

This problem will start to show itself the minute that there is a significant change in either the equities market or the market assumptions now in place concerning interest rates.

As far as regulations are concerned, they will come more than likely as a product of a debacle - not before it. In a practical sense, having regulators focusing on this area of financial instruments would cause that debacle when they came to realize what I have defined to you in this letter.

Furthermore, any new laws concerning bankruptcy as they pertain to the entities that present themselves as OTC derivative dealers would favor those dealers and not the system itself. The possibility that legislators understand the mechanics of derivatives is simply not possible in my opinion.

Respectfully,

James E. Sinclair

April 11, 2005


Mr. Sinclair's web site is here.

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