Obama’s new derivative markets shake-up promised in August to make all OTC derivatives trade on an exchange, presumably in in order to avoid credit risk. However, there seems to be a fair amount of confusion over whether the trades are speculative or simply hedges. In fact, there seems to be a fair amount of confusion. Period. Says, the Economist:

Most of the differences hinge on the definition of a “major swap participant”. No one disputes that big banks should observe tighter rules for derivatives trading, but should oil companies, airlines and fund managers, which routinely use derivatives for hedging, face more regulation too? The stakes are high. In the interest-rate and foreign-exchange markets alone, non-financial firms account for about $50 trillion of derivatives outstanding. Earlier this month over 170 firms, including Ford, Shell and Procter & Gamble, wrote a letter to lawmakers bemoaning the “extraordinary burden” they would face if they had to join clearing houses or allocate their precious cash reserves to margin payments. [link]

Now they’re holding off, and delegating it to the SEC and the CFTC (Commodity Futures Trading Commission), since nobody is sure what to do. Ferreri does make a salient point, though.

The Treasury believes banks dislike exchange-trading platforms because they narrow bid-ask spreads, undermining profitability. Others argue that few OTC derivatives markets are amenable to exchange-trading anyway. “Companies use OTC derivatives like we buy complex holidays from a travel agent,” says Christopher Ferreri of the Wholesale Markets Brokers’ Association, an industry body. “Everyone’s holiday is different and the buyer wants one quoted price.” The Committee on Financial Services removed the exchange-trading requirement (but may backtrack); the Agriculture Committee diluted the definition of an exchange. [link]

Says, Matthew Yglesias:

Good news for investors who like to lose all their money, “John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.” What’s that, you ask, didn’t his first fund lose all its money? Why, yes. And didn’t the second fund fold because it lost a ton of money? Yes, quite so. So how will this new one be different? It won’t! It’s “expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.”

The way this works is that you identify arbitrage opportunities such that you make trades you’re overwhelmingly likely to make money on. But those opportunities only exist because the opportunities are very small. So to make them worth pursuing, you need to lever-up with huge amounts of debt. Which means that on the rare moments when the trades do go bad, everything falls apart: “The strategy typically has a high ‘blow-up’ risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.” [link]

Brad DeLong responds:

Whether relative-value arbitrage is, as I think Myron Scholes once said, “using computers to suck up nickles on a global scale” or “using borrowed money to put a chip on 35 of the 36 roulette numbers and hoping for no zero/36″ and in the long run profiting from the shield of limited liabiity and your lenders’ idiocy–that is a genuinely hard problem. Which it is depends extremely sensitively on the shape of the tails of the return distribution–and that information is, of course, hard to get because the tails of the distribution are, you know, the tails, and we don’t see them very often.

John Meriwether’s two attempts to test this as a strategy rather than as a small part of the portfolio of a much better capitalized firm that can be rescued by Warren Buffett and so wait out panics have not turned out so well. So he’s going to do it again! [link]