Vanilla Options for Derivatives

I really liked writing the Vanilla Options for stakeholders, which had a Fed members talking about reforms needed for shareholders and creditors in the financial markets in a manner that sounded very similar to arguments used for vanilla options in consumer credit reform. I think it’s a neat argument, since I’m for both, but I also think its helpful in seeing how many of the same issues that effect main street when it comes borrowing and lending effect the big players who have to deal with Wall Street. And though the vanilla approach was treated as a bit fringy when it first came up for consumer finance, it’s good to see it discussed as a guideline for more general financial reform.

So let’s get another person in to talk about financial reform who seems to be using the vanilla option mentality – the move to make financial instruments more standardized, more transparent, and more easily comparable between institutions – in another context.

Rick Bookstaber is a very credible guy. Senior Policy Adviser at the SEC, after having done a lot of high-end quant work for Moore Capital Management, Salomon Brothers with the Risk Management Committee, Morgan Stanley, etc. There’s a lot of books on the lead-in to the crisis by quant/traders/financial engineers, and his book A Demon of Our Own Design is usually considered the best. I tend to find bald quant dudes credible, intelligent, and awesome just because, but his resume should make you at least listen to him.

And here he is on his blog, with The Flight To Simplicity in Derivatives:

Complexity is one of the demons that makes our financial markets crisis prone….

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

Furthermore, the thought-leaders on the buy side will add their own hurdles to the more complex OTC products. I would not be surprised if many investors require derivatives taken on their behalf be of the standardized, exchange traded form, or that if an alternative is presented, it has to be approved by their firm’s CIO or risk manager. If this comes about, there won’t be too many instances where a complex OTC is pushed forward, because for most legitimate purposes the standardized products, on their own or in combination, will be found to do the trick.

How wonderful is that? It’s complicated if you don’t know the debate, but let’s try to work through the logic. If we push for exchanges for as many derivatives as we can, which we should, once past a critical point derivatives that don’t end up on the exchange will look slightly worse than those on the exchange. They will cost more, since the spreads are less subject to competition, be less liquid, and likely to be more complex.

So someone on the buy-side will probably just choose the exchange option unless there’s real value to this new instrument or it is providing a necessary function the exchange traded instruments can’t. Clients will be in a position to say “how is this derivative better than the similar exchange-traded derivative product?”, and those selling it better have a damn good answer, because the price information of the exchange instrument will be telling them plenty.

And don’t you know, that’s the same argument that people make for the vanilla option in consumer finance! Having default generic options that are simple and easy to compare makes companies offering services have to innovate on providing better products rather than innovate on hiding fees, burying language in terms of service, and doing the best gotchas that they can do. Because if a consumer thinks he is getting ripped off, he can simply defect to the generic option – it uses market signals and incentives in a way to get financial innovation on the consumer end back on track.

(Newest one to watch out for: fees for no direct deposit, transferring from those who have recently become unemployed to help provide frequent flyer miles and free checking to those with jobs. Great job banks.)

So see, totally not fringy. It’s actually a necessary condition for us to have a functioning consumer financial market. What are some other places Wall Street could use a little vanilla action?