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A new Godfather in town

"The Godfather" logo with a one dollar bill superimposed.

KAI RYSSDAL: Stocks and bonds get virtually all the attention in the business press. But if you really want to go where the action is, dip a toe in the derivatives market. You remember credit default swaps -- those secret handshakes that three-and-a-half years ago brought us all closer to the apocalypse than we'd care to remember? Derivatives. Way too complicated financial contracts that multiplied and flooded markets virtually without oversight.

Regulators are now fine-tuning some new rules for what's being called a derivatives clearinghouse. But what exactly does that mean?

Handily, that's just the kind of question our series Economy 4.0 was set up to answer. Here's Marketplace's David Brancaccio.


DAVID BRANCACCIO: At one point in 2009, the private market for derivatives was valued at somewhere in the near $600 trillion. So there were trillions of dollars worth of promises floating around the markets that, turns out, could not be kept. But while the author of "Traders, Guns & Money," Satyajit Das, says that this market was largely unregulated, it's not that derivatives are inherently bad.

SATYAJIT DAS: Ah, it's a bit like cholesterol isn't it? Good cholesterol and bad cholesterol, it's the mix.

Das has been closely following new financial regulation that calls for a clearinghouse for these derivatives, to bring more order to this vast market. These will be companies, usually private, that register with the government to act as a kind of insurance to both sides of a derivatives contract. Let's see if a metaphor can help make this clear.

Here comes the bride music

A Pre-Cana. That's the pre-wedding classes that the Catholic Church requires for couples before they walk down the aisle. Maybe a clearinghouse is like a pre-Cana that helps set out the rules of a contract. So both sides -- the buyer and seller of the derivative -- know what to expect once they're "engaged" to be wed.

IVANKA OLESNYCKY: When you're engaged that's when you overvalue your assets, right?

Ivanka Olesnycky, the pre-Cana facilitator at a church in Newark, N.J. (St John's Ukrainian Catholic Church), coordinates a weekend of speakers who make sure this "over-valuing" doesn't cause problems for young couples later on. The speakers cover budgeting, children, conflict resolution...

OLESNYCKY: And some people at the end of the weekend they'll say "Oh we're so compatible, this is really great!" and some people say, "Wow we have a lot of work to do."

So, back to you Das, is a clearinghouse like a pre-Cana?

DAS: The contract that you're talking about is almost like what I would call a disclosure statement; an arrangement before you enter into the contract. So basically all the risks are explained, and you say "well, these are the issues that may come up, how are we going to resolve that?" and then you enter into the contract of marriage.

But a clearinghouse, Das explains, doesn't care how you came to be engaged -- it doesn't care about the Pinot Grigio you shared on your first date or how many kids you plan to have. All a clearinghouse is interested in is making sure that you fulfill your marriage contract once you've signed. In sickness and in health, in good times and in bad.

DAS: So another way of saying this in the context of the Catholic church, which is divorce is generally not allowed.

OK, so now let's try clearinghouse metaphor No. 2.

Horse race

Is a clearinghouse more like the guy you call to place a bet on a racehorse, i.e. a bookie?

DAS: No, the bookie are the derivatives traders because they're the ones taking the other side of the bet.

OK, so we now know what a clearinghouse is not -- it's not quite like a pre-nuptial counseling session, it's not like a bookie either.

DAS: OK, the best way to think about the clearinghouse is the mafia and "The Godfather."

Love theme music from "The Godfather"

DAS: You're a minor crook...

"THE GODFATHER" FILM: I'm Bruno Tattaglia.

DAS: And you enter into some contract with somebody else.

"THE GODFATHER" FILM: Speaking in Italian

DAS: And the other guy looks at you and says "Hey, how do I know you're going to perform on this contract?" And you say, "Well, I have a Godfather!"

"THE GODFATHER" FILM: Be my friend? Godfather?

DAS: And you go to the Godfather and say, "This guy doesn't trust me! So will you ensure that if anything happens to me, that he will get paid or receive his goods or whatever." And the Godfather says "Of Course!"

"THE GODFATHER" FILM: Good.

DAS: Pay me the protection money.

"THE GODFATHER" FILM: Someday, and that day may never come, I'll call upon you to do me a service.

In the Coppola film, the godfather asks for a service to be rendered sometime in the murky future. Can our godfather/clearinghouse metaphor extend this far?

DAS:
In fact, that's a very good analogy because the whole system of risk management entails people doing certain things for the Godfather to ensure that he keeps his promise and agrees to perform in your behalf for the entire life of the contract. And that's how it works.

So there you have it. A clearinghouse, a government-sanctioned company with the means and know how, will act like a godfather. A system to be sure that when it comes to derivatives, folks live up to their agreements. Or else.

DAS: Conceptually it's a terrific idea. But the devil as we always know is in the detail. And it's not an easy idea to make work.

A point recently confirmed by Commodity Futures Trading Commission Chairman Gary Gensler, who put off finalizing clearinghouse rules for derivatives until 2012, because it's all so complicated. In the meantime, the rest of us can wait and watch "The Godfather."

In New York, I'm David Brancaccio for Marketplace.


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About the author

David Brancaccio is the host of Marketplace Morning Report. Follow David on Twitter @DavidBrancaccio
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Since when did Marketplace become "Financial Markets for Dummies?" In a failed attempt to be clever, Brancaccio ended up treating his listeners like idiots. Anyone who is informed enough to care about what a derivatives clearinghouse is doesn't need inane references to completely irrelevant topics. (Given the rampant criminality in the financial markets, the godfather link may not be entirely unrelated.)
Earlier comments by H. Parmesano and S. Mandke make good substantive critiques that I won't repeat; suffice it to say that after both listening and reading, I now know what a pre-Cana is, but I remain pretty much in the dark about what a derivative clearinghouse is and how/if it works.

"it's not that derivatives are inherently bad"
Good derivatives are called insurance. So we need to regulate them for what they are.

This piece was so lame. All that time spent on what derivatives clearinghouses are NOT, but no clarity on what they actually ARE. You made it sound as if the clearinghouse provides something like insurance. If so, who pays for the "insurance" and how do we know the clearinghouse will have the resources to back up the transaction if a party does not live up to it?

Wow, a disappointing piece of reporting from David Brancaccio! You missed the forest for the trees there, Mr. Brancaccio. The primary problem with derivatives is that no one knows who is holding what. A clearinghouse is not a substitute for transparency. Better yet, the notion that the clearinghouse will somehow make these transactions "safer" and prevent the 2008 debacle is a fantasy: just because you're trading through a clearinghouse doesn't mean that you're not doing deals under the table also.

"...a derivatives clearinghouse. But what exactly does that mean?"
It means nothing. Anything that is, essentially, insurance must do two things: find a way to measure risk, and set up a reserve for that risk.

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