Tuesday, October 8, 2013

Discourse on the Great Recession – Trading Systems


Trading is the most primal of human exchanges, even in the most primitive societies comparative advantage prompted trading – the excellent hunter made a deal with the excellent arrowhead maker. The challenge in modern trading systems is the degree of abstraction that has evolved – there is no clear connection between actual human endeavor and trading – trading then hinges on the perception of value, rather than a perception of value anchored in relative human action. Absent a concrete attachment to service or product, the “castle of the mind” plays a massive role; confidence, or the lack of it determines value.

 

One of the initiating factors of the Great Recession and also the key factor in the prolonged state of uncertainty, was the inability to quantify exposure for individuals and governments due to opaque trading systems. Many of the new financial instruments were without a public forum to trade; the various assets CMO, CDO, many other Asset Backed Securities and Credit Default Swaps without a public trading forum to make public their volume and tempo of exchange or their value, the condition of the market was indiscernible by governments and individuals – there was no ability to qualify the exposure; this effected a widespread state of unease. Lending institutions with no clear assessment of other institutions exposure where hesitant to lend to one another regardless of the interbank rate determined by central banks or other factors – this caused serious consternation and retarded the availability of capital. Many of these “products” became valueless, even though the underlying assets had value, due to the uncertainty of the underling asset’s value – there was no tangible means to assess value and no open trading system to manage sentiment.

 

When you contrast these asset’s price behavior and ambient sentiment through the crisis with publicly traded products – stocks, exchange traded funds and the related derivatives – one noticed a more favourable circumstance evolve with the transparent trading system. The ability to assess the value of the underlying assets due to generally accepted and regulated accounting and reporting systems, and the presence of an open trading system together allowed a floor to form on the value of openly traded assets sooner than in opaque trading environments and the general market confidence in this space recovered more quickly.

 

Credit Default Swaps (effectively bond insurance) – for example – the sum total of the asset represent was less the total amount of “insured” value – the equivalent of a $100 asset being insured for $100,000 – default is then a favorable circumstance for the holder of swaps – the challenge of course is, the issuers of swaps often take the asset back from the entity the swap has been issued to. One can see in this circumstance how challenging it can be to assess ones exposure absent any “open” trading modality; once again negatively affecting general confidence.

 

There will always be “private agreements” between people and companies, however, when public entities are at play – publicly traded companies - as a matter of regulation concern public companies must be obligated to have the capacity to accurately disclose the value of assets they hold – this should preclude them from trading inside opaque systems with “products” that have no clear expression of value and no means to handle the realities of market sentiment.  


 

      



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