“Bucket shop” has become a general-purpose Wall Street insult – “don’t work at Blackstone, it’s a total bucket shop” – but it’s actually a particular thing, “[a]n establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in.”1 The “bucket” bit comes, I think, from the notion that your long order and someone else’s short order would be thrown into a bucket together, netting them out with the shop as a bookie, rather than being forwarded to the stock exchange.
These are illegal now in all sorts of ways, and when they existed in the olden days they seem to have been pretty shady, but I’ve always thought that as a concept they get sort of a bum rap. What’s wrong with giving people synthetic exposure to equities, particularly exposure with low initial margin requirements and limited recourse?
The European Union will be very cross if it finds out that the International Swaps and Derivatives Association conspired with its members to keep out would-be members. Read more »
So credit-default swaps have a pretty bad rap in the wake of that whole financial crisis. And people apparently aren’t interested in trading things that some parts of the general public (otherwise known retail investors) blame for the aforementioned unpleasantness without actually understanding anything about CDS.
You may not believe this, but a few weeks ago I spoke to a business school class about the financial industry, and a student asked me “what would you say to someone who’s considering a career at an investment bank?” Somehow it did not occur to me to congratulate her on her humanitarian impulses. Instead, I suggested that there are two possible futures for the big banks. In one, the various efforts to “make banking boring” – more onerous capital and liquidity regulation, clearing and futurization of derivatives, bans on prop trading, calls to break up big banks, and so forth – would create amazing opportunities for people with the intelligence, motivation, and shall we say aesthetic sensibilities to find new ways to accomplish their non-boring goals within a shifting framework. Just like changes in the tax code create work for smart tax lawyers, so changes in banking regulation and structure create opportunities for smart bankers to steal a march on their competitors.1
In general when something is headlined “A Sensible Change in Taxing Derivatives,” or “A Sensible Anything,” that’s a good sign that it’s not; things that are sensible don’t have to advertise. Also: ooh derivatives are evil ooh, so the odds are even worse. But this particular sensible change – a Victor Fleischer DealBook column about a Republican House proposal to tax derivatives on a mark-to-market rather than “open transaction” basis – is more sensible than you might initially expect; it’s mostly plausible and inoffensive and non-pitchforky.1 (The idea is straightforward: if you own a derivative, and it went up in value this year, you pay taxes on the increase in value. Unlike with, say, stock, where you only pay taxes on the increase in value when you sell the stock.)
One way to tell it’s not too bad is that various reports suggest that the Wall Street reaction so far has been “meh?” or “huh?”; this is presumably in part because it’s not clear how real this is and in part because it’s not clear how bad it’d be if it was real. Wall Street, in the sense of derivatives dealers, already pay taxes on their derivatives inventory on a mark-to-market basis, so the dealers’ dog in this fight is not their own taxes but rather the marketability of various products, from boring ETNs to lovely variable share forwards, to customers focused on tax efficiency.
Nonetheless! There are two ways to think of derivatives. One is they are a specific class of evil things, often involving acronyms, designed to let banksters get up to dirty tricks. This line of thinking goes along with words like “complex” and “opaque” – “derivatives are complex instruments …” etc.
The other way to think of the term is as a catch-all for any sort of contract whose value is determined in part by something in the world. Read more »
Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.
One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1
Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.
So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:
- You have a pool of reference assets,
- You pay some spread to a protection writer,
- If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
- So for instance if there are 40% losses you get paid 25%.
- The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.
So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:
- The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
- The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
- If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3