Over the years products and trading strategies have proliferated at the back of the development in risk pricing data and the ability to break down and slice the risk.....
The risk could then be transferred to the counterparty most willing to accept them. These innovations over the years have unlock a set of liquidity and introduced a new set of market participant........and have also contributed to the massive liquidity seen in the Global Financial markets......
All of these innovation helped the evolution towards more complete markets.......and in-turn increases overall market efficiency..
Which kinda make all those fancy formulaes workable.......
One thing about liquitity....it exist only when investors are confident and willing to take risk....and it can evoporate in seconds...as we have seen in the 2008 Subprime crisis......not only that some of these exposures can also lead to potential systemic risk to the financial system......
So where do we go from here?
For example lets look at one product.......the mother of all con job.......
The Credit Derivatives Market....
The base product provides a pay-off in the event of a default of the underlying reference entity in which the CDS (Credit Default Swap).......
Macam insurance kalau default you get the face value....
If you are long the product what you need to do is deliver the underlying bonds and the CDS writer will pay you the full value......
It was working fine in the early days....until one day Delphi defaulted and the total number of outstanding contract (USD 25Billion) is larger than the outstanding amount of the underlying bonds (USD 2 Billion).........
So the market devises a way to sort this out.....
Cash Settlement..........no need to deliver the underlying bonds anymore......
Read more about it here
What happened technically is now anyone who holds (long) a CDS on a reference entity is effectively undertaking a Naked Short Position on the Underlying Bonds of the Reference entity.......without the need to deliver the bond to the protection seller....
The market then grew to 60 Trillion USD......larger that the GDP of Planet Earth.....besau tu
Then as we all know......it came tumbling down together with the Subprime market.......
Another interesting thing about this product is that it was not Regulated .......it is not a security nor it is considered an insurance contract.......
Some talks in the early part of the crisis for this to be considered as an Insurance Product...and the writer of the Product(Protection Seller) should be treated as offering an Insurance Contract and should also be subject to the minimum prudential standards of an Insurance Firm.....
Of course the market reacted negatively.........
All those fly by night operators (hedge funds who acted as writer to CDS) and some of the Largest boys such as AIG (who acted as Market Makers and also a Net Seller of CDS) mengelabah big time....cause if this thing goes thru......habis...kaput semua......
The market had some control mechanism in-place......whereby the holder of CDS can demand collateral from the writer..........remember AIG.....they almost went bust due to collateral calls by the respective counter-parties in their CDS deal.........(who were indirectly bailed out via the Gov capital injection to AIG...hint hint if AIG failed folks like Goldman Sachs would go bust as well)
Now lets look at how the market undertake the pricing and mark to market of the product....
By design the product is linked to Default Probability....
And default probability is an annual observation.......
As simple deduction .....how can one be sure that the models to value this product is performing as how it should via the Backtesting .....i.e. comparing actual observation based on historical data to check if the values generated by the model boleh pakai atau tidak.......
lets say now the model requires a test of 252 business day observation.......
For price maybe they can get (Kencing price of course).....but for Probability of Default they would actually need 252 years data point..that would bring us back to somewhere around the year 1758
Now about the price....when the market started.......noone knew where the market is main bantai aje....and of what is the underlying bonds are linked in the CDS .....cause Company A say Ford Motors can have 10 bijik bonds.....(there was also development to standardise the contract terms....biasa la if not transaction cost mahal)
So they all got together and started sharing their data.........and then they formed a Monopoly company called Markit......
What the company did was first to create the Reference Entity Database (RED) whereby all CDS contracts will be referenced to its RED Data.......to become a subscriber you need to pay 250K US a year.....
what they did was to collect the daily quotation on CDS from the dealers.........aggregate them and then provide a theoretical price based on the quotation from dealers.....and sell it back to the dealers.....so they cycle of bullshit goes on and on.........
the Regulators as usual are slightly behind the curve on this one.......
Kalu kat sini di bilang udah ketinggalan kereta....
BTW kereta is Keretaapi in Bahasa Indonesia..
Dulu masa gua baru sampai sini, gua tanye orang nak sewa kereta.....dia orang semua terkejut
"Bapak ngreti nyetir kereta?" "Wah mau ke mana Pak?"
Anyway.....back to the regulators....
After the AIG and Subprime.....they began talking about the introduction of a central counterparty for all CDS trades...this would ensure proper collateralisation and reduce the bilateral exposure among counter-parties to trade.................(that proposal has now been approved by the US SEC to allow Clearing Houses to clear CDS trades)
To this monkey they are still not addressing the fundamental issue......
It is supposed to operate like an insurance contract if you are holding a bond ......if the bond defaults you get back the face value.....
remember the Delphy case I mentioned....the solution created the liquidity......more of the speculative liquidity to the market......pricing got better of course....
For those who are lost a simple analogy
I(not related to you) buy Insurance Policy on your life and then invite you home pastu bagi lu makan nasi campur racun?
What the market did after the Delphy is effectively that...allow synthetic naked short on the reference entity bonds....So it is in their interest that the bonds default.......
Germany have taken the lead by Banning Naked CDS position on EUROZone Debt..citing "extraordinary volatility in the markets" ...and the market is reacting negatively.....swaps spread have soared in EuroZone debt......
Germany’s ban, which took effect at midnight Frankfurt time and lasts until March 31, 2011, also applies to the shares of 10 banks and insurers, German financial regulator BaFin said in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, BaFin said.
This monkey is watching these events closely..........how will other markets react.......will this be a "permanent control mechanism" or a temporary solution.....and I also wonder how in the world they plan to implement the policy
Till then folks.......gua sudah malas mau monitor pukimak lancau politik kat Malaysia lead by a bunch of idiots on all side......