If you wonder why savvy derivatives traders rewrite contracts, Bloomberg News unintentionally provided an example yesterday evening. The home page showed the Dow at zero, down 100%. Bloomberg was apparently unaware of the error until I contacted the top of the house.

You have to plan ahead and make the terms as specific as possible. If you used Dow as a benchmark and included Bloomberg as a reference, it would be interesting to be presented with this screenshot as a pricing source by a smart-aleck. Mistakes happen even in liquid markets.

Illiquid markets are much tougher. For example, credit derivatives contracts should be rewritten for definitions including among other things: triggers for credit events; what constitutes notice of an event; what constitutes a reference entity obligation; binding notice of physical settlement, if applicable;  terms of cash settlement, if applicable; what constitutes a deliverable obligation, if applicable; and how pricing will be determined. If you are averaging a number of sources you can write in the option throw out outliers, but in addition you should also have the option to disqualify obvious errors and substitute another source.

ISDA claims its documents should be the market “standard.” That position has left investors who accepted ISDA’s narrative at a disadvantage. Moreover, ISDA has consistently demonstrated lack of vision when it has come to the dangers posed by counterparty risk and the credit derivatives market in general. There have been many examples over the years. Here’s just one from January 2008, less than nine months before the global financial crisis:

Cynical use of derivatives has market in a pickle

Financial Times (Letter to the Editor)
Published: January 31 2008 02:00
From Ms Janet Tavakoli.

Sir, Robert Pickel, chief executive of the International Swaps and Derivatives Association, made a predictable smoke-screen response to the criticism of the credit derivatives market made by William Gross, Pimco’s chief executive (“Net exposure is the best guide to derivatives’ market impact”, January 29).

Mr. Gross’s numbers may have been gross, but the debatable “net” numbers offered by Mr Pickel seem to be offered only to obscure the central point.

Credit derivatives have had an astonishing impact on the recent destabilisation of the capital markets. Here is just one example: first, lend money to mortgage lenders who will use that money to lend to people who cannot pay them back. Securitise these obligations by allowing hedge funds to put up minimal cash for the appearance of taking the first loss in a deal, and allow the hedge funds to hive off most of the excess income.

Then persuade financial guarantors to use a type of credit derivative to “insure” the “safest” part of these unstable structures. After that, use credit derivatives to transfer the middle risk that you could not sell, the mezzanine tranche, to yet another securitisation, Now do the same thing all over again.

You have just destabilised the financial guarantors, because the “safe” credit derivatives-based structures are now in danger of losing substantial principal. But you are doing fine, because you used a credit derivative to buy credit default protection on the financial guarantors from some poor sucker, who was not paying attention.

Mr Pickel would have you believe that Mr Gross made “potentially damaging errors”, but I would argue that cynical use of credit derivatives is responsible for leaving the market in a pickle.

See also:

“Hidden Bank Risks Drive Investors to Productive Assets, U.S. Treasuries, and Gold”

“Tavakoli’s Speech to the IMF on Global Systemic Risk – April 2005”

“Mon Ami ISDA: Crisis in Credit Derivatives”