How can you not love listening to Lloyd Blankfein? He spoke at this Merrill conference this morning and here are the slides, whatever; he is not a PowerPoint presenter, he is a philosopher. Let’s talk Philosophy of Lloyd.1
Lloyd and I share a number of passions, I assert without evidence, but a quirky one is that we both enjoy idly speculating about conservation laws in finance. In the Q&A Lloyd was asked about the clearing of derivatives and their movement to central counterparties, in which instead of banks trading opaque over-the-counter products with each other and their clients directly, taking client and fellow-bank counterparty risks, derivatives will increasingly trade in standardized cleared form with public pricing and central clearinghouse credit risk. Lloyd began by hypothesizing a “physical law of conservation of risk,” noting that “the things you do to reduce the risk of a 20-year-storm” – like reducing credit exposure to a bunch of different shaky counterparties in derivatives markets – “might make worse the risk of a 50-year storm,” like the credit exposure to one central counterparty whose failure could bring everyone down. I’m with you Lloyd: endorsed; narrow the distribution and fatten the tails etc.
The other concern about the move to clearing is that lots of people expect standardization and clearing will reduce the spreads that banks can charge on cleared things (mostly interest-rate swaps, some miscellany). Coincidentally a while back I speculated about a sort of law of conservation of abstraction, in which the abstract fantasies of our global financial system are built on the mucky underpinnings of a basement at DTCC full of damp stock certificates. That was … that was dumb, I don’t know what I was thinking.2 It’s obviously false. It’s the other way around actually: the more the inputs of the financial services industry abstract away from human activity, the more the outputs can move even higher up the abstraction chain. You see this with DTCC itself, which was seeking efficiency by dematerializing stock certificates even before a hurricane did that job for it, or in that Journal article last week about how Belgium is dematerializing its stock certificates and everyone’s all sad about it but the march of progress waits for no paper-hoarding Belgian.
You can see it especially Lloyd’s take on whether increased clearing of interest-rate swaps, etc., will help or hurt Goldman Sachs’s business. Read more »