How banks make money from structured products

How banks make money from structured products

Posted: Slashik Date: 05.06.2017

The mystery of derivatives, the secretive multi-trillion dollar market that few understand but is believed to be at the heart of the financial meltdown needs illumination. Without it, policy makers have no chance of getting much needed regulation right. I am no apologist for the big banks as my readers know. But the NY Times failed in its duty to provide objective analysis to the public in this instance. Of course there are no hard lines between these categories and you wont find bank financial statements organized quite like this.

Regulating derivatives is beyond the scope of this post. However I will say that it is essential to distinguish between the value of moving derivatives to an exchange and the value of centralized clearing. Exchanges make pricing transparent so customers generally like them and dealers generally dislike them. Exchanges enhance transparency and therefore hurt profitability for dealers.

However, large customers also like deep liquidity, which OTC markets can be better at providing, especially for non-commodity like products.

how banks make money from structured products

So for protecting the interests of customers, it depends on who the customer is and which products. Generalizations will be misleading. Centralized clearing is the big gorilla in the room, and at the heart of the systemic risk that has exponentially expanded with the rise of OTC derivatives and threatened to take down the entire financial system.

Interest rate swaps and credit default swaps are examples of OTC derivatives.

Beware structured products sold by your bank or building society | Money | The Guardian

The NY Times article was largely talking about OTC derivatives, although it confused the distinction.

Most experts consider OTC derivatives to be the area where systemic risk resides, which explains the desire to move much of this activity onto open exchanges with centralized clearing, similar to the way the major futures and stock markets operate. The US government bond market operates over the counter as well, but with centralized clearing. I am very impressed with this article. I would like to discuss some points raised, and have some questions also.

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Market making volumes to facilitate this end user demand constitutes probably twice the volume of the end user demand since many transactions are not simply brokered, but are positioned by dealers in similar but not directly offsetting transactions. Trading volumes expand as dealers seek to manage the underlying risk. Derivatives are particularly attractive to speculators because of the efficient imbedded leverage in them.

how banks make money from structured products

Of course this leverage creates externalities in the form of systemic risk, and therefore must be addressed aggressively with much higher capital and margin requirements. The addiction of speculation is the real story here, and we need to talk about it. It was a great age of constructively creative finance, linking capital markets together for the first time and enhancing efficiency in the process.

But the loss of resiliency was lurking in the wings.

How Does a Bank Work, and Why Do Banks Make So Much Money?

OTC derivatives are used by institutional professionals, not by individual retail investors. The heating oil distributor in the NY TImes article is more the exception than the rule and his desire for fair pricing can best be met via a competitive process check pricing with at least two banks when trading.

Institutions who lack professional expertise, engage in derivatives at their own risk since there are many complex nuances. Situations of unsophisticated end users getting ripped off by opportunist Wall Street pirates date back to the famous Proctor and Gamble trades with Bankers Trust in the s. The willful deceit, what can only be called financial evil, imbedded in the security selection, waterfall mechanics, and rating agency exploitation of Abacus type deals was shocking to this former derivatives expert as it was to the public.

BUSINESS : How Structured Products Work

Apparently it does not count as fraud. And there are 5 ways banks make money as dealers in OTC derivatives: The immense growth of OTC flow trading means that the dealers make big money if they can professionally intermediate these massive flows, measuring in the trillions.

This involves putting capital at risk so it can and does go wrong, and professionally making tight, competitive markets across multiple instruments. While there are conventional economies of scale in areas such as systems, operations, and counterparty credit management, and a subsidized cost of capital by Uncle Sam, the really valuable economies of scale exist on the order flow side.

An Introduction To Structured Products

As the industry consolidates and market share increases, by definition the dealer sees more of the flows. It makes a lot of money for Wall Street. They are dependent upon them.

This represents a dangerous accumulation of power that should be addressed by our government. Dealers speculate on numerous risks associated with managing OTC derivatives books, and utilize the advantage their market making role provides them in seeing the flows. It is ludicrous to suggest that this activity can be separated from market making.

Wall Street always seeks to add complexity to the derivatives business. On the one hand, this allows tailoring of sophisticated risk profiles, often the well-intended desire to meet client needs.

Complexity also allows high margin trades, as they are by nature, structured and negotiated rather than done via a more competitive process. It must be said that some complexity is intended to deceive and gouge clients. The more complex, the more buyers had better beware.

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Occasionally, Wall Street opportunists seize opportunities to cheat, some might say steal. Unwinding such trades when the client realizes the disaster is often a second opportunity to gouge, the deepest cut of all. JOIN MAILING LIST Email Address.

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