In options market trading ye Editor has always wondered why Naked Puts are allowed as transactions. Naked Puts mean I don’t own the underlying stock but I am guaranteed being able to sell it at a fixed price up to a fixed date. Why the transaction? If I own the underlying security a Natural Put acts as a hedge or insurance against taking a big loss if the stock takes a downturn. For a fee I limit my losses on the stock or commodity in question. But if I don’t own the stock or commodity in question, a Naked Put is just gambling. Financial analysts defend the practice by saying the Naked Puts help make the market more liquid and with so many more participants, prices become more accurate/reflective of the underlying worth of commodity or company. Ye Editor thinks of it as bald brazen gambling.
Andrew Ross Sorkin raised this question in the NYTimes regarding DOJ legal action against Goldman Sachs. Andrew asks why are synthetic CDOs , in which neither contracting party has ownership in the underlying securities [they are both naked] – why are these instruments allowed to be traded? What financial or social purpose do they serve? And given the massive derivative betting taking place and the consequences [think AIG's massive bailout] why not prohibit synthetic CDOs and other naked derivative trading?
Again, financial analysts will advance the same “increasing the efficiency of markets” arguments cited above for the validity of “Naked Puts”. But with derivatives, especially synthetic derivatives there are many flaws to this efficiency argument:
1)First for synthetic derivatives it is a pure bet for both sides. There is no underlying financial instrument for either party. It just like betting on a NFL game with your neighbor – neither you or your neighbour are financially committed to either team – you are just betting on the score;
2)Access to information on the derivative instruments is not free and open like most stock markets. The bulk of derivative transactions are done on non-open, minimally regulated OTC [Over The Counter] submarkets. Because most derivatives are traded on nearly opaque submarkets [for example reporting requirement are once every 6 months and many of those reports are just summaries with no details of individual bettors and their exposures], it is very difficult to get an overall sense of where the derivative markets are or where and what is the valuation a group of derivative instruments related by conditions or counterparties.In sum, critical info about all the conditions and counterparties associated with any or a group of derivatives may simply not be available to one or both bettors;
3)Derivative instruments can be quite complex – so both or one “bettor” may be mistaken or not be able to do proper due diligence assessment of the derivatives due to the financial intricacies Also the theory of risk for these instruments is currently under review for possible corrections;
4)Because there is minimal regulation/control of derivatives, bettors can become highly leveraged as in 2007-2009 – so if anything goes wrong a)the bettor and all associated counterparties can be wiped out in a blink and b) the current volatility of markets, with 3-5% swings in a day for the averages and 5-30% movements in individual financial instruments, inherent risk of derivatives go wrong quickly is high and many going massively wrong is not negligible.
5)The size of the the OTC derivative markets[the opaque or hidden ones] is at the last half year report in June 2011 at $707 trillion or nearly 50 times the US Total Annual GDP. It is huge as seen in the chart.
The growth of derivatives was instrumental in the 2007-2009 Financial Crisis. That growth has resumed. See here for a discussion of whether the gross or net nominal value of derivatives is subject to risk
But Andrew Sorkin does not stop here on derivative risk - he also raises fundamental fiduciary trust questions surrounding the Goldman Sachs market making activities in question. Should a market maker be allowed to assemble an investment that is designed to fail? Goldman is currently hiding under the guise that their client investors were sophisticated and should have done due diligence not trusting Goldman to supply them with a fair bet. But as just elaborated, that is a non-trivial task in the case of derivatives. Thus, Wall Street continues, seemingly without even trying, to look uglier and uglier every passing day. In sum, the article is a must read for the clarity of its questions and explanations of what is at stake in financial and particularly derivative reforms ongoing now in Washington.
This underlines the Occupy Wall Street concerns that, if the Too Big to Fail Banks and other Financial Institutions[think AIG]” Oops, do it again” – Main Street, who are still paying now with continued low interest rates on their savings without small business loans for jobs or foreclosure relief – will be saddled with the infamous Wall Street win-win proposition => “Heads-we-win-big-bonus compensation, tails-you-have-to-pickup-our-too-big-to-fail tab”.