Friday, March 26, 2010

Perception Creates Reality

A reader commenting on the previous post on CDS asked: "... if two people have a bet on a football match, does that affect the result?"

This is a seemingly innocent and deceptively easy question;  but, in fact, it is very difficult.  To answer it we must touch upon the very core of our understanding of the physical world, since it is another way of expressing a fundamental premise of quantum physics/mechanics: Does the mere observation of an event alter its outcome? (see Schrodinger's Cat).

My opinion is that yes, observation certainly affects the result.  I have already dealt with the subject from the financial markets point of view in a series that appeared exactly one year ago (Neo At The Quantum Casino - Part I, Part II, Part III).  In addition, another post dealt with the Quantum Economy (The Economy as Schrodinger's Cat).  I believe that financial markets provide the best empirical validation of this axiom because perception of a fact shapes their action, well before actual fact.  Furthermore, perception very frequently forces a fact into existence -  for example, a run on a bank.

Now, as to CDS being bets.  Yes, of course they are, in the narrow sense.  But, they are much more than a simple up/down wager of the black/red kind at the roullette table.  For one thing, CDS can also act like bonds on steroids: to the seller, a CDS provides an upfront lump sum plus a steady stream of income with little or no principal invested, depending on margin and capital adequacy requirements.  As such, CDS are a particularly pernicious way to inflate systemic leverage and further expand the debt bubble, outside any significant control or oversight from monetary authorities (shadow banking).  I say pernicious, because unlike most straight debt, proceeds from a CDS do not go to fund the "real" economy but stay within the shadow banking system.  They are just more (and more easily toppled) financial domino instruments.

Unlike a straight bond portfolio, a portfolio of CDS is, by definition, much more volatile. Because CDS are so highly leveraged a small movement in price causes large gains or losses.   And therein lies the perception problem, because a volatile CDS market produces - by necessity - increased volatility in the underlying bond market;  CDS and bond markets are interconnected like communicating vessels. A perception of higher or lower default risk is instantly communicated to the bond market via the CDS channel.

The end result is that the CDS "tail" is wagging the bond "dog".  A relatively small, inefficient, opaque and highly leveraged derivatives market controlled by a mere 4 or 5 trading banks, can wreak havoc with the biggest, most important securities market in the world - that for bonds.

Let's put it into casino terms: you are sitting on a ho-hum blackjack table where the action is small and slow.  Suddenly, a bunch of well-known high rollers stops by and starts side-betting heavily on your hand.  Would that affect your judgement and the way you place your own bets?  Of course it would..


  1. Okie, Hell's post is pertinent not just for the perception of CDS trading.
    Look at the link you stuck down in the last post "The Game is Over".
    Now... what is your conclusion based on Hell's post here ??
    Gotta be careful with prophecy.
    Gotta think twice about what you want MOST : to be right, or to make things change.
    Since you know your Bible, I presume, I will refer you to the story of Jonah (and I'm NOT talking about the whale...)
    Careful, I'm NOT saying I believe in censure.

  2. As the trigger for the post, I'm not sure you've made your case.

    1. In a CDS transaction, as with all derivatives, its a zero sum game. All that happens is money is transfered from the winners to the losers.

    2. Lets take the casino example and apply it to Greece.

    Here, Greece is the small gambler you refer too. The big gamblers arrive and between themselves start taking side bets.

    Does the fact that Greece has been cheating and has cards hidden up its sleeve matter?

    Does the fact that the high rollers know this affect how the casino treats Greece?

    ie. A lot of people want to blame the traders for not keeping their little scams quite.

    As for volatility.

    Is an illiquid market more volatile in times of stress than a liquid one? Liquidity matters if you want to hedge. If you remove the ability to hedge, that drives up costs and drives up volatility when under stress.

  3. What about the (card)-dealers? Why are they not allowed to play on the BJ-Tables?
    JPM, GOLDMAN, DEUTSCHE, BAC have quite some influence if and when a credit event might or might not occure. Should they be allowed to bet against their clients/counterparties in such a undisclosed dark way ?
    I will happen. It probably has happened. And it is criminal.

  4. Dear Lord.. :)

    1. CDS are NOT swaps and the CDS market is NOT zero sum.

    2. The fact the Greece was "cheating", as you put it, was very, very, very well known and even abetted and encouraged by those self-same high rollers, at LEAST during the 1996-2002 period. They made a pile of money during the drachma-euro convergence period.


  5. Hubert,
    re: card dealers

    You hit upon a crucial point. Investment banks (and most "plain" banks) are no longer mere brokers, or card-dealers, as you put it. They are now amongst the biggest gamblers themselves, and that's why I completely agree with the enactment of the Volcker Rule.


  6. The same can be said for any party that supports Greece. It's on the other side of the transaction. Should they be allowed to make these bets if they have a position in the underlying?

    ie. Almost all the reasons being put forward for bans on derivatives, come from people who've been exposed for incompetence because of those transactions.

    Now in the case of Greece, do you want a disaster now, or a even larger disaster latter?

    ie. It's the failure of the Greek politicians and their lies with regard to the Euro accession that have been the cause.

    The CDS trading doesn't affect that.

    On the aiding and abetting. You can't have it both ways. ie. Loan us lots of money when we want, at rates we want, with no regard to risk, to paraphrase George Papandreou.

    The only valid argument I can see that those who are anti CDS can make is that the price of the insurance is different from that implied by the actual risk.

  7. What about the (card)-dealers? Why are they not allowed to play on the BJ-Tables?


    They do. The card dealers are the governments, and they are playing with the public's cash.

  8. 1. CDS are NOT swaps and the CDS market is NOT zero sum.


    Why is it not a zero sum game?

    1. Who are the parties to the CDS?

    A. The buyer of protection.
    B. The seller of protection.

    2. Who pays who?

    Seller receives premium from buyer. No money destroyed here.

    In the event of default. Buyer receives money from seller. No money destroyed either.

    It's a zero sum game. No money is destroyed, just transfered.

    As for making money from CDS transactions. No money was made. It was just transfered from the losers to the winners.

    It's a zero sum game.

    So if Goldman made money, perhaps you can tell us who sold them protection?

  9. A hedge fund buys a CDS contract from a bank for a price that comes to the equivalent of $10 million present value. The hedge fund borrows this money (or, say, 90% of it) from another bank, or even the same one (that's what Prime Brokerage is all about).

    After 5 years the CDS expires worthless because the underlying entity did not default.

    a) What happened to total money supply?
    b) Is this a zero sum transaction?

  10. Essentially, the CDS market becomes the game. Comparing it to betting on a football game is not a good analogy.

  11. A hedge fund buys a CDS contract from a bank for a price that comes to the equivalent of $10 million present value. The hedge fund borrows this money (or, say, 90% of it) from another bank, or even the same one (that's what Prime Brokerage is all about).

    Is that 10 million face value or 10 million pv of premium?

    Why are you now trying to twist?

    Is it fractional reserve banking or CDS that concerns you? You've never mentioned fractional reserve banking until now? ie Why bring in money supply to avoid the zero sum game issue.

    To keep it simple, lets look at the cashflows for a 1 year CDS. Premium paid up front. On default, 10M is paid out.

    Scenario A - No default.

    Bank A pays bank B 1 million
    Bank B receives from A 1 million.

    -1M + 1M = 0

    So a zero sum game.

    Scenario B - Default

    Bank A pays bank B 1 million
    Bank B receives from A 1 million.

    -1M + 1M = 0

    All happening on day 0

    On the payment date after default.

    Bank A pays bank B 10 million
    Bank B receives from A 10 million.

    -10M + 10M = 0

    Again a zero sum game.

    So where is a CDS contract not a zero sum game?

  12. Essentially, the CDS market becomes the game. Comparing it to betting on a football game is not a good analogy.

    So if its just another game, why does it matter?

    ie. There is the CDS game where the participants freely choose to enter into bets.

    Then there is the borrow and lending game. Here govenment want to borrow, and people might lend. The problem for governments is that the lenders are cottoned on that they may not get the value of what they lent back. As a result the lenders will lend if they get a guarantee (CDS), or they get higher interest rates. It's the same thing. Government's however are having a hissy fit. They don't understand why people won't lend to basket cases. ie. Why should the cost of borrowing of the UK government be more than Buffet's borrowing costs? It's quite rational.

    Hence the response from governments. It's not us, its some other bogey man. It's the banks, its the hedge funds. It can't be our spending adiction, we're the good guys.

  13. Um Hell, re: zero sum game

    Aren't you the one always reminding us of the conservation of energy as well?

    I think the issue you have convinced the rest of us on (or at lest me) is why talented people are wasting their time fiddling with this nonsense in the first place.

    I can't eat CDS, nor will they cure my neighbor's cancer, etc...

    It is just glorified betting and that seems to me a real waste of time except for it's small entertainment value.

  14. In a previous post you said this

    Likewise, the vast majority of CDS traders/speculators/hedgers have next to zero desire to deliver (or take delivery of ) the underlying bonds

    You seem to think that this is a bad thing.

    1. What's wrong with a hedge?

    2. Should insurance in general be banned?

    3. The non delivery of a bond for a CDS. What's bad about that? You seem to want all CDS's to go bust so that delivery is made.


  15. It is just glorified betting and that seems to me a real waste of time except for it's small entertainment value.

    So, do you have any insurance? It's an identical product. Should that be banned?

  16. @ Debra:

    I have no idea what you are talking about.

    Conclusion? With regards to what?

    Prophecy? What am I supposed to predict?

    Jonah? (And not the story of the whale?) Some other Jonah? And what is the reference to the current post?

  17. Okie:

    You need to read Xeankis.

    That's what she's talking about.


    It's glorified betting, but it's the ticket to fame and fortune on Wall Street for some.

    Win on Wall Street, and you get the brass ring! You can tell your kids about the glory days when you traded CDS and how you were better than everyone else!

  18. So, do you have any insurance? It's an identical product. Should that be banned?

    Ah, but Lord Blagger, this may be your problem. You see, in the United States (your info says you are in England), under the U.S. law passed in 2000 CDS contracts were forbidden from being regulated as futures or securities.

    In the U.S., insurance is regulated at the state level. But CDS are specifically exempt from these regulations. There have been calls to regulate CDS as insurance, but it is being fought by the banks.

  19. This comment has been removed by the author.

  20. I do have insurance so I see your point.

    ... Oh well, another zero-sum issue. How unusual. ;-)

    Back to faith and cooperation again.

  21. Okie, you can't regulate the human heart no matter how hard you try.

    ... I have a solution! Maybe we should let Norwegians write all CDSs? ;-)

  22. jp:

    I still don't see the connection. Give me a link and I will read it.

  23. How do I link on this thing?

    I'm used to push button linking on chat boards.

  24. Thai:

    It's insurance plus, so to speak.

    It's a financial instrument that can also be used for manipulation of other things for the purposes of making a profit, if I understand it correctly.

  25. Just to make a small prediction. We will have someone along who will say, look, CDS's is like trading in insurance on something you don't own.

    ie. Me taking out life insurance on someone else where I have no financial interest. That's should be banned.

    A direct analogy in the games world would be to say that only the players in a game are allowed to make bets. Hmmmm.

    However, if you aren't allowed to be involved in insurance unless you own an asset, doesn't that ban the insurer from getting involved?

    Ah, you can sell insurance on something you don't own. You can't buy insurance on something you don't. Perhaps that's a good rule, or is it?

    So lets see about the insurer. There is what is called the re-insurance market. Here an insurer buys insurance for something it doesn't own, in order to hedge its exposure. The rule above would ban that, and lead to a vast increase in risk for insurers, with the likelyhood that more go bust, and the customer is left out of pocket.

    ie. It goes back to some of the real falicies about any market.

    1. The market is going down because people are selling, or the market is going up because people are buying. Falicy is that buyers and sellers are matched.

    2. All this trading provides nothing. It does, its called liquidity.

    So lets say you want to go on holiday and want some mexican pesos. No speculators means no middle men. You have to find a mexican coming to the US and wanting to change money from pesos to dollars. No speculator - no banks or bureau do change. They are speculating. Buying now at one price and hoping to exchange later, and making a profit.

    However, the general point about observations affecting things I think is valid, and the effect is good.

    ie. CDS spreads showed just how much a basket case Greece was. Equaly, you could just compare the spread between German and Greek bonds. It's the same thing. I don't notice many complaints about that.


  26. It's a financial instrument that can also be used for manipulation of other things for the purposes of making a profit, if I understand it correctly.

    Such as? (apart from making a loss)

  27. jp:

    Follow me:

    type < a href="put the link here (just copy and paste it)">after you close the > you can put any text you want to link then < /a>

    Do this without the space between the < and the a href" and without the space between the < and the /a

    and viola, you should have a link.

  28. Uh, Lord Blagger, normally I don't point out other's misspellings; but the word is "fallacy" not "falicy."

  29. On my speling, no offence taken.

  30. Lord Blagger, You make a lot of great points but the issue for me is that:
    1. The CDS market is larger than the underlying markets. It's not really hedging or insurance (or not generally).
    2. This creates more systemic risk.
    3. Which would be fine except the government tends to bail out failed financial players (eg AIG).
    4. I don't understand how these instruments (except bona fide hedging) actually support the real economy. What am I missing?

  31. Okie, I was not criticizing you in any form in my remark. I was critical of the author of your link.
    Saying the game's up in the context of Hell's post, where... perception creates reality seems... ill advised to me. Doesn't bolster any.. FAITH in our ability to work our way out of this mess.
    Jonah, chapter 3 and 4.
    The Lord mandates Jonah to go to Ninevah and tell the people to repent, and... the people repent..
    And Jonah is all pissed off because he wanted to see a scene out of the Raiders of the Lost Ark.. where God got all angry.
    The guys who wrote the Old Testament were aware of the fact that prophecy comes as naturally to men (and women) as breathing.
    That's why they cautioned against.. FALSE prophets.
    You know ? People like.. Adolf Hitler. Or, on a much smaller scale...Rush Limbaugh, for example... (from what I HEAR on this blog, at any rate. Expatriation has some advantages. Some)

    For Lord Blagger.. A rose BY ANY OTHER NAME, does it smell as sweet ?
    We are in agreement about the... CULTURE/ECONOMY of insurance.
    I wish you guys would all read "The Merchant of Venice" by my dear Will. Just the... casket portion would do you ALL good.
    To "obtain" Portia, her suitors have to choose between THREE caskets : one gold, one silver, and one.. lead.
    Here is part of the tirade of Arragon, the ill fated suitor who chooses the... silver casket.

    ..."Gold, silver, and base lead.
    "Who chooseth me must give and hazard all he hath".
    You shall look fairer ere I give or hazard.
    What says the golden chest ? Ha, let me see !
    "Who chooseth me shall gain what many men desire."
    What many men desire -- that "many" may be meant
    By the fool multitude that choose by show,
    Not learning more than the fond eye doth teach...
    I will not choose what many men desire,
    Because I will not jump with the common spirits
    And rank me with the barbarous multitudes.
    Why then, to thee, thou silver treasure house !...
    "Who chooseth me shall get as much as he deserves".
    And well said too, for who shall go about
    To cozen fortune, and be honorable
    Without the stamp of merit ? Let none presume
    To wear an undeservèd dignity,
    THE WEARER !...
    How many be commanded that command..
    But to my desert..

    HE DOES NOT PASS GO. He does not collect... $3 billion dollars. Obama (whoops, Arragon) does NOT save the U.S. economy...

    Here is what he gets instead of salvation. A note, with this on it :
    Some there be that shadows kiss ;
    Such have but a shadows bliss.
    There be fools alive iwis (I know)
    Silvered o'er, and so was this."

    Silver in the play is a metaphor for "that common drudge twixt man and man" that money is.
    CDS's, insurance, the whole speculation game offer a fool's head and a shadow's bliss to those that... kiss them.

  32. Re: CDS increasing systemic risk

    I don't know much about CDS but I will say this, as I do know a fair bit about disasters- let's say my work bumps me up against it not infrequently.

    Anyway, what is absolutely clear from the data is there has been a massive increase in both the scale and number of natural disasters over the last 50 years. And disaster epidemiologists have studied this issue at length asking the simple question: "why?"

    And you know what they found?

    People are putting themselves in harm's way more now than ever before?

    And so the same epidemiologists asked again: "why?"

    And guess what they found (again)?

    People believe more than ever that they can get away with all kinds of stuff because they have insurance. I mean the places people now build there homes is simply beyond the logic of common sense. But of course, these places are very alluring.

    And still we keep on picking up the tab.

    Never let throwing someone else's perfectly good money after bad prevent you from doing it yet again.


  33. 1. The CDS market is larger than the underlying markets. It's not really hedging or insurance (or not generally).
    2. This creates more systemic risk.
    3. Which would be fine except the government tends to bail out failed financial players (eg AIG).
    4. I don't understand how these instruments (except bona fide hedging) actually support the real economy. What am I missing?

    1. The reason why the market is larger than the underlying market is quite straightforward. If it wasn't the case, you wouldn't have liquidity. ie. Having a large pool of willing buyers and sellers means that if you want to trade you can.

    However, there are cases with CDS where this has caused problems in the past. It's largely technical but I'll explain.

    Some CDS contracts have default conditions where the seller of protection will buy the physical bond at par on default. So the person who's insured the bond just delivers the bond and gets the full value. The loss to the seller is 100 * (1-recovery rate)

    Now some buyers of protection didn't hold the bond (think about reinsurance). They then had to buy the bond in order to deliver it. That drove the price up to well above the recovery rate.

    Since this has happened almost all CDSs have move to cash settlement. A panel works out the price, and its just cash that changes hands.

    So back to the trading volumes. If a share is traded many times a year, is that wrong? The trading volume is more than they number of shares in existance?

    ie. Back to the insurance and re-insurance. The volume will be larger than the actual amounts insured. However I see no problem there. Why is there a problem with a seller of insurance, insuring themselves (Hedging) with someone else?

    How can you tell it creates systemic risk? If a bank hedges out its credit risk, its less likely to go bust. If its less likely to go bust, then systemic risk goes down.

    As for bailouts, I'm dead set against it. They should have been left to go under. Banking and socialism don't mix.

    They support the economy in various ways.

    1. Making the cost of credit risk explicit.

    2. Allowing people to tailor their risk.

    ie. Back to the perception creating reality.

    Does measuring the risk of Greece going bust, mean that the risk changes.

    Would the non existance of a CDS market mean that Greece had no risk of default?

  34. Ho hum.
    All this talk about Greece.

  35. Lord Blagger, you didn't read my comment carefully...

  36. "If a bank hedges out its credit risk, its less likely to go bust. If its less likely to go bust, then systemic risk goes down."

    I suspect that this statement is wrong as it seems to violate the laws of physics.

  37. Nothing to do with physics.

    Let me explain systemic risk. It's the risk of contagion. A failure of one bank causes failures of other banks, which ....

    Why do banks go bust? They go bust in part because their clients go bust. Think of the US where all those customers defaulted on their home loans. The banks lose money. They go bust when their losses exceed their capital.

    So, if a bank hedges its credit risk, it doesn't lose capital when a customer defaults.

    ie. Hedging out your credit risk reduces the probability of going bust.

    Now, if you don't go bust, you can't cause a systemic risk event.

    So, perhaps you can tell us why you think the opposite is true and why?

  38. LB,

    If AIG were allowed to go bust, it would have brought down many big banks and caused financial meltdown (i.e. systemic risk.) Note that many of these banks were "hedged" but they would not have survived the crisis.

    CDS is not a football game. No one should be allowed to bet on people/country's livelihoods. If CDS were regulated, we would not be dealing with this mess.

  39. There are banks, "banks" and "other financial institutions". Unfortunately, we have managed to mash them all together into a big lump and allowed them to play with fire, regardless of who they are and what their role is - or should be.

    The comment section is too small so I will write a post on this..

  40. Little old naive me. I thought that banks went bust when people RAN on them for example.
    Like when EVERYBODY wanted their money AT THE SAME TIME.(Sheds a new perspective on the retirement of the baby boomers, right ? LOTS of people wanting their money at the same time..)
    Now.. if everybody DOESN'T WANT his money at the same time, there should be some... MARGIN for the banks to be able to do business WITHOUT having the whole system grip up.
    The CDS question looks to me like... ANOTHER door opening. As I go blue in the face remarking on this blog, one of the first doors that was opened to get us where we are now was the one that Calvin forced open at the reform, the one that got Protestant (Christian...) banking going. On the INTEREST QUESTION. Making money AT THE SAME TIME, AND AT THE SAME LEVEL, the symbolic INSTRUMENT of exchange AND... the OBJECT of that exchange. There goes an important distinction/difference RIGHT OUT THE WINDOW. (I really should take a look at how the Catholic Medicis were doing their banking. But NOT on Wiki. God help me...)
    Geez, Hell, "arguing about money as though it were a question of the number of angels on the head of a pin" ?
    Money IS indissociable from theology. For all the old reasons that I keep saying, like.. throw God out the door, and he comes back through the window IN A FORM UNDER WHICH YOU WILL NOT NECESSARILY RECOGNIZE HIM.

  41. Like it or not, Debra, most all people WANT to believe in something. Be it God, Godot, natural selection, quantum physics, ethereal thought waves, that reality is as we see it, the value of money, whatever.

    God, therefore, is NOT a construct of our thoughts and desires.

    He/she/it IS our thoughts and desires.



  42. Heart attack.
    YOU are sermoning ME on BELIEF ?

  43. Oh dear.. sermonizing? I tend to be insufferably didactic on occasion, but sermons I leave to Baptists, Methodists and Mullahs.

    I am rather Socratic: "I only know one thing, that I know nothing".

    Be well and prosper,

  44. C'mon now, Deb, how can you say, "on a much smaller scale...Rush Limbaugh?"

  45. Why, Edwardo ?
    Do you think that I am minimizing Rush ?
    Sorry about the spelling mistakes.
    Fallout from being between two continents..

  46. It was meant to be an allusion to Rush's physical size.

  47. Believe it or not, Edwardo...
    I have NEVER SEEN Rush.
    One of those incredible advantages that comes with expatriation...
    On gambling and risk..
    It would seem that man is a gambling animal that JUST HAS TO HAVE HIS DOSE (fix ?) OF RISK, (like he has to have his dose of arguing about the number of angels on the head of a pin...).
    So... what are we going to do in our society to ensure that the risk that makes us truly LIVE does not take us down ?
    And anyway, maybe the "solutions" can only be at an individual level...

  48. And Hell ?
    Perception creates reality.
    Language creates perception.
    Love those Matryoshka dolls, dixit Thai.
    Tune in to my future posts about the lexic in structural linguistics (if you aren't already tuning in...) for a future installment on how banking becomes "banking". Actually banking does NOT become "banking". The meaning of banking changes in opposition to other words in the linguistic (social) system..
    The meanings of our words are ALWAYS changing.
    And.. our perception changes with them.
    So... banking does not become "banking"... Lord Blagger, I am starting to find your point of view very interesting. A retournement de veste ? Maybe.
    I reserve the right to change my mind on things at all times. And rechange it on occasion too.