According to the Bank for International Settlements, the total outstanding notional amount of OTC derivatives stood at $647 trillion at the end of 2011, up from about $80 trillion in 1998. And the total outstanding notional amount of OTC credit default swaps grew from 918 billion in 2001 to $62 trillion in 2007, and then fell to $28 trillion in 2011. Of this amount, the top 25 banks held a notional value of $14 trillion CDS in 2011. This is why we are stuck in too-big-to-fail bank zombie land after all of the banks (less Lehman) got bailed out by the government and Fed. They are too big and interconnected to fail, and can't adapt with the modern times of transparency. So the game will continue as planned until tech and banking entrepreneurs reinvent the financial system, or a huge crash occurs that knocks down the aging financial infrastructure and clears away the inefficient dark markets filled with fraud.
How did Alan Greenspan seriously believe that an unregulated, illiquid, interconnected, and non-transparent over-the-counter derivatives market, controlled by investment banks, insurance companies, and hedge funds, would prevent control fraud (Janet Tavakoli, Bill Black) and be sophisticated enough to manage risk and leverage to avoid systemic risk? LTCM already proved that financial institutions leveraged 25-to-1 with large OTC derivatives positions on with banks, would need to be rescued if they collapsed to prevent a financial crisis. And LTCM's collapse didn't even involve fraud (right?). Look what Greenspan said to Brooksley Born about fraud during a lunch meeting in 1996.
From Stanford Magazine:
“Well, Brooksley, I guess you and I will never agree about fraud,” Born, in a recent interview, remembers Greenspan saying.
“What is there not to agree on?” Born says she replied.
“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.
I think Greenspan meant to say that OTC derivatives should be traded on a regulated, efficient, transparent, and liquid (or illiquid) public exchange. Seems like a better way for fraud to benefit the public markets and economy, in my opinion. Here are examples of fraud in the OTC credit default swaps market in a Bloomberg article from 2006: Credit-Default Swaps May Incite Regulators Over Insider Trading.
``In a market that is completely opaque, all sorts of abuses are made easier,'' said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission, which regulates U.S. futures trading. ``The temptation to make money, in a way that would be unacceptable in a regular market, is just too great,'' said Greenberger, a professor at the University of Maryland School of Law in Baltimore.
No one is sure who has oversight of credit-default swaps, financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They're part of the explosion in derivatives, or contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather."
"Destroying their clients through the use of inside information" is a benefit from fraud?
"``What I find oddest is there has been very little forward movement in people admitting'' that insider trading is going on, said Jeff Lenamon, who trades credit-default swaps at Diversified Credit Investments in San Francisco. ``It needs more oversight.''"
"Chris Dialynas, a managing director at the Newport Beach, California-based firm, wrote a report in 2002 calling for the Federal Reserve and regulators to check whether banks were using private information to reduce their loan risk through credit- default swaps, which he said threatened to undermine confidence and curb trading in fixed-income markets.
``Credit-default markets are the mechanism within which friendly commercial bankers and others privy to inside information can profit by betraying and destroying their clients through the use of inside information,'' he wrote at the time."
Remember... Bankers started to create credit default swaps that referenced subprime mortgage-backed-securities and subprime MBS indexes (ABX) in 2005 and 2006, which they sold to hedge funds and other counterparties. And then banks and hedge funds started to gamble in synthetic CDOs like a poker game, which eventually pricked the credit bubble (1. Wall Street Wizardry Amplified Credit Crisis, 2. The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going, 3. Abacus 2007 CDO Pitch Book Had Securities One Notch Above Junk, Four Months Before Two Bear Stearns Credit Funds Blew Up).
"The rise in the number of hedge funds making loans to companies and protecting their bets with derivatives may be opening holes allowing information to get out, said Timothy Johnson, one of the study's authors. Hedge funds are private pools of capital that allow managers to participate substantially in the gains on investments made on behalf of clients.
``If you want to get access to information private banks have, you go and buy a piece of a bank loan,'' said Johnson, now an associate professor of finance at the University of Illinois at Urbana-Champaign in Champaign, Illinois."
"``We're approaching the tipping point,'' Greenberger said. ``There's going to have to be a reporting system. People should be able to look and see what's happening.''"
And we still don't have credit default swaps on exchanges yet? My final post on this subject will have quotes from heads of futures exchanges at a 2000 congressional hearing on OTC derivative deregulation. FYI: Brooksley Born gave a new warning in the video. The problem still hasn't been solved.