God, ethics and credit default swaps

Kenneth Hayne’s focus on the ethical failings in Australia’s financial system echoes the efforts by Pope Francis to call out the allegedly immoral activity in global financial markets by high-frequency traders and speculators in complex interest rate derivatives.

There are uncanny parallels between the impact of the Hayne inquiry and the international response to a Vatican research paper which attacks a range of financial market activities regarded as part of the fabric of the global financial system.

This week, the chairman of the US Commodity Futures Trading Commission, Christopher Giancarlo, came out staunchly in defence of derivatives, in particular, credit default swaps. His comprehensive defence of financial markets follows the publication of a Vatican paper analysing ethical behaviour, or the lack thereof, in financial markets.

In Australia, the Hayne inquiry exposed a breakdown in corporate cultures and the abandonment of ethical principles by a minority of employees in banks, insurers and wealth management companies. It has sparked a debate about why certain employees lost their understanding of the difference between right and wrong.

FRG USE ONLY. David Rowe. 14 March 2018. Kenneth Hayne, Royal commission into banking Chanticleer cartoon 14 March 2018
FRG USE ONLY. David Rowe. 14 March 2018. Kenneth Hayne, Royal commission into banking Chanticleer cartoon 14 March 2018

daniel.gray

The inquiry also exposed a tendency for many large institutions to adopt a legalistic and obstructionist approach when faced with the consequences of their mistakes. This imbalance of power is a theme running through the analysis of financial markets by the Vatican.

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Concerns about a credit squeeze and a possible regulatory onslaught that will suppress entrepreneurship prompted industry leaders in Australia to remind politicians of the key role played by banks in the intermediation of savings.

Then, last week, the chairman of the prudential regulator, Wayne Byres, defended the right of banks to make a profit and the necessity for banks to be able to enforce their right to recover the security held against loans that have not been repaid.

The research paper commissioned by the Pope, Considerations for an Ethical Discernment Regarding Some Aspects of the Present Economic Financial System, also recognises the importance of money being made from human activity and the need for well functioning financial markets.

“Money in itself is a good instrument, as are many other things at the disposal of the human person, and is a means to order one’s freedom and to expand one’s possibilities,” the report says.

J. Christopher Giancarlo, chairman of the Commodity Futures Trading Commission (CFTC), has come out swinging.
J. Christopher Giancarlo, chairman of the Commodity Futures Trading Commission (CFTC), has come out swinging.

Patrick T. Fallon

“Nevertheless, the means can easily turn against the person. Likewise, the financial dimension of the business world, focusing business on the access of money through the gateway of the world of stock exchange, is as such something positive.

“Such a phenomenon, however, today risks accentuating bad financial practices concentrated primarily on speculative transactions of virtual wealth, as well as negotiations of high frequency trading, where the parties accumulate for themselves an excessive quantity of capital and remove the capital from circulation within the real economy.”

The Vatican paper reserves its strongest criticism for credit default swaps (CDS), which are used to insure against the risk of bankruptcy. The total notional amount of credit default swaps at December last year was $US9.4 trillion, according to the Bank for International Settlements (BIS).

The paper, also known as the Bolletino, says CDS permit gambling at the risk of the bankruptcy of a third party.

“The spread of such a kind of contract without proper limits has encouraged the growth of a finance of chance, and of gambling on the failure of others, which is unacceptable from the ethical point of view,” the paper says.

“In fact, the process of acquiring these instruments, by those who do not have any risk of credit already in existence, creates a unique case in which persons start to nurture interests for the ruin of other economic entities, and can even resolve themselves to do so.

“It is evident that such a possibility, if, on the one hand, shapes an event particularly deplorable from the moral perspective, because the one who acts does so in view of a kind of economic cannibalism, and, on the other hand, ends up undermining that necessary basic trust without which the economic system would end up blocking itself. In this case, also, we can notice how a negative event, from the ethical point of view, also harms the healthy functioning of the economic system.”

Giancarlo at the CFTC says the Vatican’s depiction of speculation as “morally illegitimate” is not helpful as a practical guide to differentiating between acceptable and unacceptable activities.

“Debate about the role of speculation is likely as old as markets themselves and will not be resolved here.

“Let the following, therefore, suffice: First, whatever its definition, speculation contributes to the societally beneficial generation of information and the dissemination of that information to the public at large.

“Second, whatever uses of CDS are considered appropriate and unobjectionable require a counterparty on the other side of the trade. A “speculator” that sells CDS protection, for example, may very well be the only facilitator of a pension fund’s purchase of CDS protection to hedge the credit risk of its bond holdings. Without such a speculator, the pension fund would be unable to hedge and acquire the bond in the first place, which would thwart economic activity.”

CDS have come under considerable scrutiny from regulators in recent years because of their abuse by market participants. A paper published late last year by the BIS found that CDS had been used for insider trading.

Earlier this year the International Swaps and Derivatives Association said it would institute measures to stop CDS market participants entering into arrangements with corporations that are narrowly tailored to trigger a credit event for CDS contracts while minimising the impact on the corporation.

The BIS study could find no evidence that banks use the CDS market to lower regulatory risk-based capital ratios, or in other words to seek capital relief.

“Finally, our results show that the main lender in a syndicate tends to insure more of its credit risk than its partners and therefore has less at stake if the firm defaults,” the BIS said. “This exacerbates the uneven distribution of information and can distort market functioning.”

The issue at the heart of the BIS and Vatican criticism of CDS derivatives is the asymmetry of information. In other words, all the information is in the hands of the creator of the financial instrument.

The Vatican says that “in a asymmetrical situation it would be possible to take advantage of a lack of knowledge or of the contractual weakness of either counterpart”.

“The complexity of numerous financial products currently renders such asymmetry an inherent element of the system itself and puts the buyers in a position inferior to those who commercialise these products – a situation that from several aspects leads to the surmounting of the traditional principle of caveat emptor.”

But the CFTC’s Giancarlo says financial markets encapsulate all available information in the price of a financial instrument.

He says a hedge fund that buys CDS protection because it thinks a corporation will struggle or even fail is obviously trying to profit in the event of the corporation’s decline.

“From this perspective, the hedge fund, along, in fact, with all of the other market participants is generating information and trading,” Giancarlo says.

“They are all hoping to earn superior financial returns but, in the process, also disseminate the information they have generated to the broader market.”

Giancarlo says it is wise to be sceptical of overly complex derivative products, like CDS tranches on mortgage-backed securities, “which traded in great volume in the run-up to the 2007-2009 financial crisis”.

“We also agree that buyers of CDS protection, who stand to gain from defaults, must not be allowed to conspire to cause those same defaults or make them more likely,” he says.

“As officers of the CFTC, we are committed to policing CDS markets, along with all other derivatives markets, with the view, in the words of the Bollettino, of advancing liberty, truth, and justice.”

Tony Boyd

tony.boyd@afr.com.au

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