Will Price Discovery Help or Hurt the Derivatives Market?

One of the much touted provisions of the summer's financial regulation bill was its intent to have standardized derivatives placed on exchanges. Policymakers asserted that this would provide greater transparency to the market. That may be true, but it's not entirely clear that all aspects of this transparency will do more good than harm.

Currently, both the Commodities Futures Trading Commission and Securities and Exchange Commission are working on implementing new rules surrounding derivatives. Ben Protess at DealBook explains one of the big changes the SEC is proposing that would occur through exchanges:

But financial regulators are now on the verge of equipping investors with crucial information that has long been secret: The price at which derivative contracts are trading.

At first blush, this sounds great. Shouldn't the market know the precise prices that are paid for derivative contracts? After all, that's how it works with publicly traded stock, and it appears to work pretty well. The derivatives market is a little different, however, and there could be unintended consequences from greater price transparency.

First, it's important to realize that the stock market is far more liquid than the derivatives market. In other words, for very liquid stocks, there are many shares outstanding and generally lots of trades each day. For example, Apple has 921.28 million shares outstanding, and in the last five days has seen trading volume over 78 million.

Now let's consider a derivative. In fact, let's compare it to credit default swaps on Markit CDX-NAIG, which is an index of North American investment grade debt. It has the highest number of standardized CDS contracts at 40,206. It traded 417 in the past week. Compare those statistics to what we saw above for Apple's stock. The ratio of Markit CDX-NAIG contracts outstanding to Apple stock is 0.0005%. The ratio of trading volume for the CDS to the stock is 0.004%. As you can see, these are very different markets.

Currently, investors can already see where prices are quoted for such standardized derivatives -- they just don't see the precise price paid. Providing additional transparency could adversely affect the end-user firms that use swaps to hedge various risks. The problem stems with the liquidity difference that just explained.

Let's consider a historical analogy. When Walt Disney decided to build his Walt Disney World theme park in central Florida, he was very savvy about his method for acquiring the land. At the time, it was mostly farm land, which meant it was dirt cheap. But he didn't want the farmers to realize that someone with deep pockets was interested in buying up a huge chunk of continuous land. He also didn't want real estate investors to find out, which could trigger a burst of land speculation. Both of these consequences may have led him to pay more for the land than its market value, since people would have caught on to his plan. So he created dummy corporations to purchase the nearly 30,000 acres of land.

Now think about a firm that wants to buy a large hedge against some foreign exchange like the Japanese yen. Currently, the market only knows where the price of such a derivative contract is quoted. But if an exchange provided the quantity and price of all transactions to all investors, then other investors would catch on to the firm's strategy. As a result, those investors could hamper the liquidity of the yen hedge, and either prevent the firm obtaining it altogether or make it much more expensive to do so. Like the land in the Disney example above, this derivative could no longer be obtained at its market price if there was more transparency surrounding purchases.

This sort of problem is possible in the derivatives market, but not in the stock market, due to the liquidity differences described above. It's pretty hard to move the market in a highly traded stock, but it's much easier to do so for a derivative, since a particular standardized contract's number and trading volume is so much smaller.

It's not hard to imagine a trading platform taking in the newly provided derivative exchange data to make an arbitrage profit. As soon as a computer program observes a company beginning to acquire a position in a particular derivative, it can move in and make similar purchases quickly, or refuse to sell its holdings of that contract to the company at a fair market price.

Of course, there's a flipside. Sometimes these firms know more about some aspect of their businesses than the rest of the market, which causes them to hedge some risk they discover. This information could sometimes be useful for the market to take into account sooner. For example, if Countrywide (before it was swallowed by Bank of America) realized that subprime mortgages were defaulting in late 2006, it might have sought to buy a heap of protection against its mortgage exposure. If the market catches on to such risks sooner, it could correct distortions before they get worse.

So it's really a question of how the cost benefit analysis of this new rule works out. Instead, it could be a good compromise to ensure regulators have all this trade data, so they could spot the risks sooner, but not the market. Then, investors wouldn't be able to manipulate derivative trades. The harm that could result if end-users have to pay more for derivatives due to investors having more power through this additional transparency has the potential to be harmful to Main Street firms' hedging practices.