Yesterday, the news hit that the Department of Justice is investigating Markit, the major provider of derivatives data, pricing information and indices. That news failed to explain why the DOJ was so interested in Markit, though speculation pointed at antitrust. Today, the Wall Street Journal reports that hunch was right. In trying to understand how large banks, through Markit, might be manipulating derivatives pricing, I realized something: I don't understand how the derivatives market works. And neither did anybody else I asked.
I mean, I understand basic market process and the derivatives themselves. But if you asked me procedurally what traders did, how the big banks might have an unfair advantage under the current system or what should be done to fix it (if anything), I couldn't answer. I worked at a bank originating bonds, but like most others in financial services, I was never actually exposed to what traders do. I just called them from time to time to ask them about the market.
The people I asked also had trouble explaining derivatives. And I'm not talking about the guy who makes my sandwich at the deli downstairs. I consulted a derivatives lawyer to see if he could explain the pricing mechanisms. He couldn't. I called up a major banking lobbyist to see if he could explain. He couldn't either. I asked him to see if he could dig someone up to talk to me about how the market works. He said he would call me back once found someone. He never did.
Why does nobody understand the derivatives market? Probably because, up to now, nobody really cared how the derivatives market worked. It just did. Then, credit default swaps shook the earth. Suddenly, regulators care, politicians care and investors (who lost lots money on seemingly safe bets) care.
I'd love to find someone who could really explain the ins and outs of the derivatives market. What do derivatives traders do day-to-day? How do derivatives traders at banks like Goldman manage to make billions? What unfair advantages might big banks have in the market that could be angering the Justice Department? What regulation should be imposed to make the market better?
If you're up to the challenge, comment away and let us know. If you think you can write a lucid explanation, we might even ask you to do so for our website.