Bailout

When pension funds shun OTC derivatives

By Felix Salmon

Has Illinois’s Kevin Joyce been reading Andrew Clavell? There’s something quite elegant in its simplicity about this:

Illinois is considering a bill to avoid derivatives abuse by public pension funds, Pensions & Investments reports. The bill, which is under discussion at the Illinois House Rules Committee, will restrict the state?s public pension funds from investments that trade derivatives in non-public markets.

In reality, it’s not the pension funds which are engaging in “derivatives abuse”, but rather the investment bankers who sell the pension funds complex over-the-counter derivatives which make the broker lots of money and which rarely do any good for the end client. As Clavell says,

Let’s assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense…

Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The really elegant part of this bill is that it allows investments in traded derivatives, and therefore gives the sell-side an incentive to find tradable alternatives to their beloved OTC derivatives. If a large chunk of the buy-side adopts this kind of policy, we could achieve by market forces the move to derivatives exchanges which is proving so hard to legislate.

Full post as published by Macroprudential on February 10, 2010 (boomark / email).