Re: General Theory seminar

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Ronald Calitri wrote:

>    We are better off taking account of the structural finance opportunities
> offered by the business of taking opposing positions.

Current reality is a little more complex.
There is a serious problem of the systemic socialization of risk
through structured finance.  The widespread use of derivatives to
unbundle risks so that hedging against dis-aggregated risks can be
priced at the highest level to serve those with targeted specific needs,
(and therefore willing to pay the highest price for its management), creates the
false impression of individual safety through extensive risk
management.  For the same cost, all risk takers can afford more risk by swapping
the unwanted protections.  This tends to cushion the downside (through risk
management complacency) and inflate the upside (through ballooned efficiency
expectations). Yet in fact the same degree of risks remains, because individual
risks are only passed on to systemic risks, but the nature of the risk has
become more serious, and added economic value comes mainly from accounting
creativity by turning risk into growth.

The counterparty of every hedge is a speculator, and in some blazen cases, the
lack of regulation and transparency has permitted the counterparties to be the
same entity, as in the case of LTCM in which some of its 60,000 complex trades
unknowing actually bet against others made by its other traders.

Further more, when efficiency is defined as achievable via a reduction of
caution, a higher peak then requires a lower valley. The defining characteristic
of a bubble is that everyone inside the bubble crashes at the same time.
Structured finance has made that prospect more likely and less preventable.

By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of financial
derivatives.
International finance in recent years has been saturated with disastrous and
scandalous abuses that clearly and repeatedly epitomize the deficiencies of the
unregulated global inter-linking of financial markets.
Speculators have been blamed for precipitating the run on Asian
currencies that started the financial crises in 1997.  Yet speculation and risk
management are two sides of the same coin.  At the opposite end of a prudent
hedge, a speculator is required.

In a structurally flawed system, perfectly honorable businessmen or institutions
individually true to high ethical and financial standards, can unwittingly
participate in systemic games of dubious value.  Data on the Asian financial
crises show that currency hedging individually by sophisticated businesses and
alert government bodies, domestic and foreign, as protective measures against
foreign exchange exposures in both debts and revenues, have been critically
exacerbated the sudden currency turmoil in the region.

In international finance, a game of musical chair in financial risk is in full
force in which the players are handcuffed together through inter-linking
hedges.  This game can cause serious systemic rupture when the music stops.

Specifically, the increased risk associated with a financial environment which
profits from instability characterized by abrupt and unpredictable change and
flux, has created a demand for financial instruments to protect against that
risk.  But the search for protection itself creates more need for protection.
These instruments, generally called derivatives, can be defined simply as
dis-aggregated or "unbundled" contractually created rights and obligations, the
effect of which is to create a transfer or exchange of specified cash flows
between counterparties of coupled opposing needs at defined future points in
time.  However clever or complex these contracts are structured, one party will
suffer at the end of the contract, either in real losses or opportuinty costs.
There is yet no true win-win hedges invented, the equivalent of the economist's
free lunch.  The best is merely to externalize the loss away from the
contracting parties, usually to the system and only temporarily.

The size of the invisible money pool created by financial derivatives is now
many times (no one knows how many) the amount of M3.  One firm alone (LTCM) in
1998 commanded open positions of US$1.2 trillion financed by up to 100-fold
leverage in extreme cases (an average of 25-1).  That is over half of the entire
daily transactional value of the world's foreign exchange markets at that time.
Another hedge fund (Tiger Management) suffered an asset evaporation (loss) in
the amount of US$20 billion in 6 hours by a 10% appreciation of a single
currency (yen) against the USD in 1998.
At year-end 1998, U.S. commercial banks, the leading players in global
derivatives markets, reported outstanding derivatives contracts with a notional
value of $33 trillion, a measure that has been growing at a compound annual rate
of around 20 percent since 1990.
Of the $33 trillion outstanding at year-end, only $4 trillion were
exchange-traded derivatives; the remainder were off-exchange or
over-the-counter (OTC) derivatives, namely between counterparties.
On a loan equivalent basis, a reasonably good measure of such credit
exposures, U.S. banks' counterparty exposures on such contracts are
estimated to have totaled about $325 billion in December, 1998. This
amounted to 6 percent of banks' total assets way above the equity
requirement level.  What's more, these credit exposures have been
growing rapidly, more or less in line with the growth of the notional
amounts.

A Bank of International Settlements survey for June 1998 estimated that size of
the global OTC market at an aggregate notional value of $70 trillion, a figure
that doubtless is closer to $80 trillion today. With
allowance made for the double-counting of transactions between dealers, U.S.
commercial banks' share of this global market was about 25 percent, and U.S.
investment banks accounted for another 15 percent.  While U.S. firms' 40 percent
share exceeded that of dealers from any other country, the OTC markets are truly
global markets, with significant market shares held by dealers in Canada,
France, Germany, Japan, Switzerland, and the United Kingdom.

The fact is: risk is now taken and hedged for profit rather to achieve security.
The taking of risk is treated an a productive act rather than a cost.
The idea of an "individual" trader and his particular psychology does not seem
to be very pertinent in this context.

Henry C.K. Liu