Exchanges Are Great, but Not a Silver Bullet

Another often recommended solution for better financial market stability is to put all derivatives on exchanges. This idea has also been championed at the Financial Crisis Inquiry Commission this morning. A witness mentioned earlier, University of Maryland Law Professor Michael Greenberger, argued for putting all derivatives on exchanges. He further asserted that this would allow the market and regulators to know prices, instead of relying on "algorithms." These contentions are pleasant fantasies, but here's a dose of reality.

Greenberger first says he likes exchanges because he believes instantly knowing the values of derivatives would be helpful. Then regulators can to do a better job of forcing companies to put up cash if the securities begin to produce losses. While that might help with some derivatives, it won't with quite a few of them. The problem is that you can't regulate liquidity.

Take the New York Stock Exchange, for example. Prices are updated continuously. The way they're updated isn't magic: it happens every time a listed stock trades. Whatever price it last sold for becomes the latest market price.

But many of these derivatives are customized, which means they don't trade very much, if at all. If a security last traded a few weeks ago, or even a few days ago, its market value may very well have changed since then. In a time of economic turmoil values might change drastically from day to day. If an illiquid derivative is put on an exchange, this won't help matters, because that price will quickly go out of date. So regulators won't be any better off in case of illiquid securities. Just because you list something on an exchange doesn't mean you'll necessarily know its current market value.

Greenberger next talks about how he likes exchanges because they simplify market prices. He uses stocks as an example of why it's nice to have exchanges. He says, when it comes to derivatives, he'd rather rely on a market price than a complicated algorithm. This point is fundamentally incomprehensible.

That stock price isn't magically bestowed on to investors. Traders and equity analysts spend countless hours developing complicated financial models to determine how to value stocks. That neat, simple market price? It's based on an equation too. And how these calculations are done varies based on the assumptions used by each investor. This is one reason why people buy and sell stocks -- because they believe the market has undervalued or overvalued them. Just because you think Apple might have a good quarter doesn't mean you should buy its stock: it could be vastly overvalued.

The idea that more knowing market prices through an exchange would suddenly prevent bubbles is ridiculous. To see why, just look to the Internet bubble of the late 1990s. The entire problem with a bubble is that the market makes a mistake. Even if every derivative related to housing were on an exchange, the same outcome would have occurred. Companies like AIG would still have collapsed. The market simply got it very wrong.