Monday, March 09, 2009

Scholes on Over-The-Counter

Bloomberg reports:
March 6 (Bloomberg) -- Myron Scholes, the Nobel prize- winning economist who helped invent a model for pricing options, said regulators need to “blow up or burn” over-the-counter derivative trading markets to help solve the financial crisis.

The markets have stopped functioning and are failing to provide pricing signals, Scholes, 67, said today at a panel discussion at New York University’s Stern School of Business. Participants need a way to exit transactions and get a “fresh start,” he said.

The “solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over,” he said, referring to credit-default swaps and other complex securities that are traded off exchanges. “One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices.”

Scholes also recommended moving the trading of credit- default swaps, asset-backed securities and mortgage-backed securities to exchanges to allow for “a correct repricing” of the assets. The securities are currently traded between banks and investors, without any price disclosure on exchanges.

A total of $531 trillion in outstanding derivatives contracts traded over-the-counter as of June, according to the International Swaps and Derivatives Association. They were mostly interest-rate swaps, but also included CDS and equity derivatives.

“Take the pricing mechanism from the desks in banks, which have made a huge amount of profits over the last number of years, and facilitate price discovery,” Scholes said.


Among other recommendations, Scholes urged changes to the accounting rules to give better disclosure on risks, said that banks should focus on their return on assets instead of return on equity, and said central bankers shouldn’t try to quell market volatility, which provides a natural brake on risk- taking.