December 6, 2010

The holidays came early this year to select media outlets that were given a sensational gift, an assortment of more than 250 thousand confidential US diplomatic cables, compliments of their not-so-secret Santa, Wikileaks. Oh, the stories that have come out so far! From secret negotiations to juicy gossip on global leaders, the cables provide rich content that will be the source of headline stories in many countries for months to come.

On the heels of this massive data dump, our very own U.S. Federal Reserve has now revealed the recipients of its emergency liquidity facilities (ie, “Fed Loans”) and the list of sellers from whom the Fed purchased assets during the credit crisis. As part of the Dodd-Frank bill, Congress mandated that the Fed spill the beans on who received cash from U.S. taxpayers, how much, and how many times, during the period December 1, 2007 to July 21, 2010. The data shows the Fed as not only the lender of last resort to domestic financial institutions, but apparently as central bank to the world as well, with billions of dollars lent to foreign entities throughout the crisis.

These extraordinary disclosures, both voluntary and involuntary, are at the same time captivating and absolutely terrifying. While they flow from different sources of authority (one legitimate, one not so much), both disclosures seek to provide transparency and open a window into little-known practices and policies of global importance. But some people would take the concept of transparency, which is generally considered a good thing, and elevate it to the point of virtue. In this utopia, they imagine no more secrets, no more closed doors, and a free flow of information to every citizen. You can almost hear John Lennon singing the praises of this would-be world:

Imagine full disclosure
I wonder if you can
No need for airport scanners
To expose your fellow man
Imagine all the people
Naked, on your plane, yoo-hoo-oo-oo-oo…

There are clearly limits to our comfort with disclosure and transparency, which is why we believe that those who act as if it is a virtue are misguided. Most people would prefer not to fly clothing-optional, nor reveal their credit card, bank account or social security numbers to the public. Some of the involuntary disclosures by Wikileaks are incredibly worrisome, and could put our armed forces in danger, or foreign sources at risk of prosecution or worse. And the U.S. Department of State must now give every country on its holiday gift list that reset button that went over so well with Russia last year (along with a heartfelt apology), lest they throw our diplomats out the door. Not surprisingly, there are also limits to the benefits of full disclosure in derivative markets as well.

Chatham Financial has long been an advocate for transparency, and we regularly provide our clients with knowledge of where their transactions execute relative to the mid market value, for example. This derivative pricing transparency allows our clients to execute at more competitive levels, and challenges counterparties to value transactions in line with their actual costs and potential credit exposures. While we see price transparency as positive for our clients in this case, at the same time we would not support full transparency if it were detrimental to our clients in the process. For example, when executing large transactions that may potentially move the market, we may be best suited to remain vague prior to the trade about timing, amounts and other details to avoid the possibility of front running. As long as the auction is fair and everyone has the same information, the exact intentions may be revealed only just prior to execution, in some cases. Other times we may privately negotiate with a single bank on a large transaction so that they are able to offload their risk without the market reacting and leaving the dealer bank with a big loss. In these cases, transparency would be very expensive to our clients, as the greater uncertainty gets priced into deals.

Chairman Gensler and the CFTC have aggressively pursued increasing pre-trade price transparency for OTC derivatives. Some markets, like those for LIBOR interest rate swaps, are so liquid and deep that maybe your trade doesn’t move the needle, and would benefit from additional viewers and bidders. But if the notional is billions instead of millions, or the structure is complex or the index less liquid, transparency in such cases could push the market higher before the end user locks in a rate or price.

There are clearly substantial benefits to disclosure and transparency, and that is why it has been a driving force at Chatham for years ; however, it is important to understand that there are limitations to these benefits, and transparency must be introduced in a careful and balanced manner or the result can be unwelcome, unwarranted and maybe even unsightly! And even if introduced carefully, transparency is no substitute for the true virtues of honesty and integrity that you would hope to see in your trading and business partners.