Today’s WSJ op-ed page has a curious defense of keeping more-complex derivatives off exchanges. It goes like this: when someone (like John Paulson) takes a short position on a derivative (like a synthetic CDO), that’s really important information for the market to have since it signifies John Paulson’s opinion that the thing tied to the derivative (like the U.S. housing market) is due for a tumble. Therefore, derivatives should remain opaque, private contracts.
In other words, who is doing what with derivatives is so important that we should only let a small club of financially interested players get a view.
Kind of nonsensical, right?
The alternative is what Congress is currently attempting to legislate: putting derivatives on exchanges so that trades are visible, and using a central clearinghouse so that folks have to prove that they’re good for the bets they’re making. Call me naive, but it seems like that set-up would go a lot further in spreading the word that people are betting against a particular asset class.
L. Gordon Crovitz, who penned the WSJ op-ed, doesn’t specifically say why the information contained in Paulson’s bet wouldn’t translate to an exchange/clearinghouse, but (if I’m connecting the dots correctly) he feels that if synthetic CDOs had to be traded on an exchange then they wouldn’t exist in such a robust way because it would take longer to come up with standardized contracts and there wouldn’t be as much profit to collect since the whole system would be more transparent and efficient. Considering that Paulson made $1 billion on his bet, I’m guessing that he would have found a way to make it, with or without an exchange.
More broadly, though, Crovitz is probably right—an exchange would dampen the speculative trading of synthetic CDOs and their ilk. But would we be losing more in terms of market information than we would be gaining in terms of market stability?
I doubt it. Consider the recent housing bubble. How many investors decided to get out because they knew someone was taking short positions against house-related synthetic CDOs? I can’t put a number to that, but the answer is definitely many fewer than were getting in because of the false promise of low risk and high return.
Point of fact is, in advance of the financial meltdown there were plenty of Cassandras for anyone willing to listen. The real problem is that no one did. So should we err on the side of market information or market stability? I say stability.