Much more time is spent promoting institutional arrangements of “constructive ambiguity” (e.g. Bretton Woods) than pointing out short-falls with transparency. The problem is that what’s being argued for under the aegis of “ambiguity” is just flexibility, mostly in the form of deferring decisions. (Not to mention that institutional arrangements can also become inflexible.) Clearly ambiguity is desirable when it manifests itself as flexibility, but this does not mean that ambiguity is desirable in and of itself. Best makes some pertinent observations (that are, for instance, relevant to CDS dynamics) but tries to wrap them up in a pleasingly ironic theory that alone threatens to undermine her conclusions. Early on, she tells us that she is “drawing inspiration from both postmodernist and critical theoretical traditions.” The thematic emphasis on ambiguity is no doubt influenced by such strains of thought, which stress “the irreducibility of difference.”

The early Bretton Woods regime is lauded for its ambiguity and “continuous deferral” of adjustments, and this points the the fundamental problem in the analysis. While active trading may increase short-term volatility, the author espouses a philosophy of deferral that is actually more dangerous and more at the cause of the financial crisis than active trading. Deferral of pricing creates the illusion of constancy where there is actually change, and enables longer-term booms and busts that are more pernicious and cause longer-lasting pain and dislocation than the “intersubjective” spirals the author warns against.

Take an example: traders push CDS prices up, causing the underlying entity’s borrowing costs to rise, thus ensuring default. This “intersubjective” dynamic would not be possible were there not already a fundamental basis for concern over the entity’s debt — if the entity had not already irresponsibly deferred its obligations. Which problem is more fundamental? This of course is exactly what happened in the credit crisis, as banks refused to transparently price their holdings. “Continuous deferral” is a recipe for less frequent, perhaps, but almost certainly more intense explosions. Is this kind of deferral not at the heart of the impending entitlement crisis, another kind of “off balance sheet” debt? It doesn’t matter if pricing will never have a perfect technical solution, you still try to price up to the point of ambiguity, which, as Best repeats, is always there anyway.

Lastly, the author holds out the Bretton Woods period as one of unsurpassed prosperity while ignoring the corresponding population boom and other factors contemporaneous with the currency regime. For their sake, Keynesians need to heed the demographic winds more closely.

[Originally posted to Amazon, 2/15/10.]

Dealers on exchanges charge clients a fixed commission to trade; the cartel of dealers means that clients have no choice other than to deal through them. The dealers are fierce advocates of competition except where it affects them.

In the OTC markets, dealers are more creative — they ensure that the clients do not know the true price of what is traded. The lack of transparency lies at the heart of derivatives profitability. You deny the client access to up-to-date prices, use complicated structures that are hard for them to price, and sometimes just rely on their self-delusion.

In the late 1990s, I was visiting Mumbai. The stock exchange was debating a move to electronic trading, but there was resistance. They invited a Nobel-Prize-winning US financial economist to speak at the conference, seeking to win over brokers to electronic trading. The economist spoke eloquently and movingly of ‘greater trading efficiency’, ‘lower transaction costs’ and ‘greater pricing transparency’. The audience was almost in tears — of laughter.

It’s one thing when opaque markets allow dealers to disguise trading costs. Our traders in Mumbai knew that to be a real source of profits, and one that would merely bleed their clients. More insidiously, opacity allows losses to be mis-represented. Before even considering the shortfalls of the Gaussian, it’s obvious that the surest way to deliver a shocking tail move to the market is to just not mark (that is, mis-mark) prices. It’s not clear to what extent the meltdown was actually a failure to predict as opposed to the result of skewed incentives and conflicts of interest along the chain beginning with mortgage origination and ending with the shareholders, who may have not even realized that they were in the security warehouse business. The models and the rating agencies gave the “right” answers, but who thought they were the correct ones?

In any case, the market thinks that public exchanges and clearing companies are among the winners. It was only a few months ago that the DOJ questioned the legality of exchanges such as CME operating clearing businesses. There is little doubt that the “Four Seasons” consortium of banks was behind those concerns. We haven’t heard from that group for a while now, but perhaps soon. One is tempted to quip that they might be down to only one or two “Seasons”, but the banks that make up the consortium stand relatively strong.

Meanwhile, the CME’s regulator finds that its prestige has increased relative to the SEC. Why should the CFTC be under periodic Congressional review but not the SEC?

Timely public prices and agent incentives make a crucial difference. I hope that the implementation of TARP and other government programs will not be lacking on these points.

[Cross-posted from Risk Markets and Politics]