Winter Patriot Community Blog

Scholes Advises ‘Blow Up’ Over-the-Counter Contracts (Update2)

By Christine Harper

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.

CME, LTCM

Scholes served almost eight years on the board of CME Group Inc., the world’s largest futures market, until his term expired in May, said Allan Schoenberg, a CME spokesman. CME operates the Chicago Mercantile Exchange, Chicago Board of Trade and New York Mercantile Exchange. He was a partner in Long-Term Capital Management LP, the hedge fund whose $4 billion loss in 1998 set off a near-panic in financial markets and prompted the Federal Reserve to orchestrate a bailout by 14 lenders.

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.

Comments Are ‘Misguided’

Scholes’ comments generated opposition from the International Swaps and Derivatives Association, the industry group that sets trading standards for the over-the-counter derivatives market. ISDA has more than 800 members, including dealers and funds that trade in the market.

“Whatever your views on derivatives or credit-default swaps and the financial crisis, the notion that you would, as he said, blow up, the business in that way is just misguided,” said Robert Pickel, chief executive officer of ISDA. “I don’t know what people are thinking when they say those kinds of things.”

Scholes won the Nobel Prize for economics in 1997 along with Fischer Black and Robert Merton for their Black-Scholes model of pricing options, contracts that give the buyer the right, but not the obligation, to purchase a security or commodity at a later date for a specified price.

He is now chairman of Platinum Grove Asset Management LP in Rye Brook, New York. The hedge fund was forced in November to freeze investor withdrawals after a surge in redemptions.

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.

To contact the reporter on this story:
Christine Harper in New York at
charper@bloomberg.net.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aBDLzTYzuxl0&refer=home