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By Ronald Fink
Improved transparency will not necessarily prevent derivatives from creating systemic risk, new research finds. But neither will require sellers to maintain some skin in the game when they unload them.
Proposals to reform the market for credit default swaps and other over-the-counter derivatives would require that they be traded on exchanges or that sellers back them with more collateral. Both ideas assume that providing investors or regulators with more information about pricing and assurances on the underlying quality of the assets will reduce the risk they pose to the financial system. Another proposal would require sellers to maintain at least a 5 percent equity or "junior" stake in contracts that have been securitized, in effect, vouching for the quality of the assets sold by accepting the first loss.
But a paper published on Monday, entitled "Computational Complexity and Information Asymmetry in Financial Products," suggests that these proposals will not go very far to reduce the risk that derivatives pose to the financial system.
The research, by Princeton University scholars Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge, finds that the analysis required to price derivatives is so complex that their risks will remain hidden, and that sellers of derivatives that are securitized can therefore "cherry pick" the best assets when retaining a junior tranche. The authors contend, moreover, that such complexity is likely to defy even the most sophisticated computational capacity.
"It may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields," Arora, Barak, Brunnermeier and Ge wrote. "This result immediately posts a red flag about asymmetric information, since it implies that derivative contracts could contain information that is in plain view yet cannot be understood with any foreseeable amount of computational effort."
The findings contrast with previous research that found securitization of financial contracts reduced risk by "completing markets" and helping ameliorate the effect of asymmetric information, what academics call the "lemon problem" associated with the fact that buyers of used cars invariably know less about their faults than sellers do.
But the authors of the new paper say such a view of securitization should be revised in view of their findings. "Even the most sophisticated investment banks such as Goldman Sachs cannot be fully rational since they do not have unbounded computational power," the paper observed. As a result, the authors continued, "designers of financial products can rely on computational intractability to disguise their information via suitable cherry picking." And they said that because dealers can generate extra profits from this hidden information -- "far beyond what would be possible in a fully rational setting" -- policymakers should think twice about "the accepted view about the power of derivatives to ameliorate the effects of information asymmetry."
The authors concede that this risk is greater in customized deals between two parties than in the far more common securitized ones. But they say they found that even the lesser risk in securitized swaps is too complex to accurately model.
"The lemon problem clearly exists in real life (e.g., 'no documentation mortgages'), and there will always be a discrepancy between "the 'buyer's model' of the assets and the true valuation," the authors noted. And since they show accurate pricing is mathematically impossible even when inputs are known by buyers, they wrote, "one fears that such pricing problems will not go away even with better models." If anything, the authors concluded, "the pricing problem should only get harder for more complicated models."
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