Listed vs. OTC: Why the NYSE is not the Problem

At the heart of the 2008 crash were a number of opaque, complex products with three-letter acronyms: MBS, CDO, and CDS. These products that have devastated our economy all have one very important thing in common: they were all traded over-the-counter (OTC).

One defines an OTC product by what it is not: if it is not traded on any financial exchange, it’s an OTC product. Since it is not traded on a public exchange, an OTC product is nothing more than a handshake between two people and a legal document outlining the terms of the trade.

You can think of an OTC trade as a bespoke suit. Instead of going to a department store and buying something off the rack, in a set size that may not fit you, you visit a tailor, who makes a custom suit tailored just to you. Because it’s tailor-made, you’re going to have to pay more for it.

But the bespoke aspect of OTC trades is only one reason Wall Street’s large institutional clients found them appealing. The other appeal of OTC trades is that no one, except the person on the other side of the trade, knows it’s happening. That’s appealing because when you trade on an exchange, the trade’s volume is made public. If you want to trade 10 million shares of Apple, and you start selling, everyone else watching the market may say, “Whoa, someone just sold one million shares of Apple stock in the last few minutes. What do they know that I don’t know? I better sell, too.” And then everyone piles on and starts selling too, and before you’ve finished selling what you want to sell, the price has plummeted. Now you’re stuck selling at a much lower price than when you began selling.

Wall Street loves OTC trades because anything custom-tailored costs a pretty penny more than a boring old listed product anyone could get off an exchange. But there were two things far more dangerous about these OTC products than the fact that they have allowed Wall Street to price gouge their clients. What is was most dangerous about OTC products are the following:

1. There is no way of knowing how many OTC products are out there.
2. These products are largely unregulated

Why are OTC products largely unregulated? In 2000, after heavy lobbying by the finance industry and by Enron, Congress passed the Commodity Futures Modernization Act. This act deregulated Over-the-Counter derivatives. It didn’t happen without a fight. Under the leadership of Brooksley Born, the Commodity Futures Trading Commission, which oversees derivatives trading, requested that there be “functional regulation” of this Over-the-Counter derivatives market. Their request was denied. The CFMA was introduced to Congress on the last day before the 2000 Christmas recess. It was not debated in the House or in the Senate. Worst of all, it contained a specific loophole for Enron that exempted portions of their energy trading from regulation. (To learn more, read Barry Ritholtz’s book Bailout Nation, p.139).

The main argument in favor of the CFMA was that OTC trades happen between sophisticated parties, and thus did not require oversight by the regulators. Unfortunately, we all now know where these sophisticated trades by sophisticated parties took us.

This is all in sharp contrast to the stocks traded on the New York Stock Exchange, or NYSE for short. While a hallowed and important symbol of Wall Street greed historically, the NYSE in recent years has been a fairly benign actor in the crisis. The kind of trading that happens on the NYSE has been regulated since the 1930s, when the Securities Act of 1933 and the Securities Exchange Act of 1934 were passed to regulate the stock market and improve transparency.

The NYSE trades stocks of companies like Whole Foods (WFM). They open at 9:30am and end trading at 4:00pm. Every single minute that trading occurs, you can see the volume of shares that have changed hands. You don’t know who traded, but you know how many and at what price.

The NYSE has a list of companies they trade. There is a certain application process a company must go through to be eligible for trading on the NYSE. Any company that successfully applies is then “listed” on the NYSE. A Listed Product is any product, be it a stock or a derivative, that is listed on an exchange. There are many exchanges other than the NYSE. To name just two, there is the Nasdaq, which trades many tech stocks and smaller companies, and the Chicago Board Options Exchange (CBOE), which trades options.

But what, you might ask, is an exchange? Exchanges are public marketplaces where buyers and sellers come together, and the volume of all trades are made publicly available.

There are other factors that make listed products more transparent than OTC products. They have set expiration dates, and have standardized contracts. Data regarding trading volumes and prices is made public for all listed products. Finally, listed trades all go through clearing houses.

A clearing house ensures that the trades made are actually executed. If I promised to pay the farmer $30,000 for 5,000 bushels of corn on November 2nd, and I didn’t pay, the clearing house would pay the farmer for me. How can the clearing house afford to make that promise? Several ways: they can require that participants post collateral, they can monitor how credit-worthy the participants are, and finally, they charge all members fees that go into guarantee funds for use when needed.

In the world of finance, what happens on the NYSE and on exchanges is considered transparent, simple, and even a bit quaint. The sexy stuff, the profitable stuff, and the extraordinarily dangerous stuff is all OTC. OTC trades that are opaque and custom-tailored are more valuable to Wall Street’s institutional clients, and thus more profitable to Wall Street. Until, of course, they aren’t.

Part of what made the crash so severe was that the warning signs were somewhat shrouded in fog. Because many of the riskiest products were traded over-the-counter, no one realized just how many of these Wall Street was creating and stockpiling. Further, no one realized how reliant on each other some of these companies had become. Goldman Sachs, for example, had a vested interest in AIG not failing because Goldman held thousands of CDS trades with AIG that Goldman wanted to be paid for. Perhaps if the public, or the regulators had known that there were so many outstanding CDOs at the six big banks, someone would have sounded the alarm before everything crashed and burned.

Examples of OTC Products

Mortgage-Backed Security (MBS) – An MBS is a large number of mortgages (e.g. 1000) pooled together and turned into financial products (i.e., securitized). Think of it as taking 1000 mortgages, putting it in a box, and selling that box to someone.

Instead of a commercial bank having to keep all the mortgage loans on their books, it can sell them off via an MBS. The buyer of an MBS receives a rate based on what home-owners are paying to the bank. The risk for the MBS buyer is that either the underlying mortgage will be pre-paid (via refinancing or pre-payment), or that the mortgage will default.

Collateralized Debt Obligation (CDO) – A CDO involved taking hundreds of MBSes and structuring them into tranches. Again, think of a CDO as hundreds of MBS boxes put into an even larger box, and then sold off. Except this box is divided up into sections: the tranches.

The tranches are varying levels of risk, based on the credit-worthiness of the mortgage holder. A tranche full of subprime loans would receive a higher interest rate payment, but has a higher risk of the underlying mortgages defaulting, which would result in the CDO tranche becoming worthless.

Credit Default Swap (CDS) – You can think of a CDS as an insurance policy that protects against the default of a company. If you want protection against the possible default of a company, you could buy a Credit Default Swap on that company. You will pay a quarterly fee for this protection (much as you may pay an insurance company a premium for insurance on your car or apartment).

With real insurance, there are laws preventing someone who doesn’t live in a house from taking out fire insurance on that house, because that creates perverse incentives. Because CDSes are not legally considered insurance, there are no laws against holding CDSes on companies you have no reason to need insurance on. So there is a perverse incentive for a CDS holder to do what they can to make the company they hold a CDS on fail, and fail hard.

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3 thoughts on “Listed vs. OTC: Why the NYSE is not the Problem

  1. It is difficult for the average American to conceive of OTCs. They cannot understand how the growth and bursting of the real estate bubble is related to what happened to their 401ks. As far as they are concerned, stupid people took out mortgages they couldn’t afford and it is these people who are to blame for their own woes. This drives me crazy.

  2. Nice one-pager. Of course the 2003-2008 fraud based CDSes were not traded. They were private contracts, only by briblical magic not regulated under New York State and United Kingdom and Irish insurance law.

    Same for the vast bulk of mortgage-traunchie CDOs. (Normal CDOs are a different animal altogether.) I sat through a number of the presentations for these things. Again, another species of fraudtastic magic ensured. “AAA” from hard cash bribes, the most of it. Too good to be true — an extra 1,500 “AAA” prime assets conjured from Mr. Henry Paulson’s wand.

    Common law fraud is dead as a criminal charge. Get over it.

  3. Unfortunately it is not as simple as that. You would need to distinguish between securitized derivatives (such as CDOs) and bilateral OTC contracts (such as CDS). To add to the complexity, scuritized derivatives can also be traded OTC, i.e. without going through an exchange, but they are usually settled through a clearing agent, such as Euroclear or DTCC. The economics and the transparency of the two types of derivatives are very different but the generic risk profile are, or can be, identical.

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