OTC

You know the official version of how god's bank, aka Goldman, makes money: in the traditional, and not at all mysterious god's way, as a pureplay investment bank, which allocates capital, provides financing, advisory services, etc. Despite what Mr. Blankfein would want you to believe, that's only half the story. This two part PBS Series analyzes the other side of the equation. Who should know the truth better than former Goldmanite, Nomi Prins, author of "It Takes a Pillage." Classical investment banking function is a small portion of their revenues, I think it is about 10% or so. So if he is doing god's work, he is only doing it 10% capacity. The rest is prop trading." But wait, according to Goldman prop trading accounts for only 10% of revenue. Why the discrepancy? Simple - because that 80% "vacuum" is really just the client-facing prop/flow fixed income hybrid model, which after the disappearance of all big fixed income trading houses (Bear, Lehman and soon, RBS) Goldman has now monopolized. Being able to determine how big or small the bid/offer spreads on anything from cash bonds, to CDS to various non-CDS OTC derivatives should be, courtesy of having the largest fixed income inventory in the world at any one time, to which it can add or from which it can sell, makes Goldman not so much a pure play prop trader, as a market monopoly, which has to be dismembered as it now is the market (just like the Fed is the market in MBS and Agency paper) when it comes to all non-Fed dominated Fixed Income and OTC derivative products. This is, and always has been, an FTC issue: remember Ma Bell?

Brazil's BOVESPA and the Merc entered into a Memorandum of Understanding as Global Preferred Strategic Partners to jointly develop a new multi-asset class electronic trading platform, with capacity to process transactions in less than one millisecond for equities, derivatives, fixed income securities and other exchange-traded or OTC-traded assets. Based on technology derived from the CME Globex® trading system, this new platform will house all BVMF segments under the same infrastructure. [1] Cliffs Notes highlight of the press release in toto ~ [2] Daily & Weekly CME charts

And you thought the $23 trillion in backstops for the financial system was bad, you ain't seen nothing yet. Earlier today, the Depository Trust & Clearing Corporation, best known for its Cede & Co. partnership nominee which is the holder of virtually every single physical stock certificate in the known universe, and accounts for over $2 quadrillion in stock transactions per year, announced that "the Federal Reserve Board had approved its application to establish a DTCC subsidiary that is a member of the Federal Reserve System to operate the Trade Information Warehouse (Warehouse) for over the-counter (OTC) credit derivatives." With this approval the DTCC is now the de facto legally accepted global repository for over-the-counter credit derivative transactions. Simply said, the Federal Reserve is now the guarantor behind all CDS transactions that clear via DTCC, which would be pretty much all of them (sorry CME, you lose). The total bottom line in terms of gross notional? 2.3 million contracts with a gross notional value of $25.5 trillion. When the next AIG implodes, and the CDS market is once again facing annihilation in the face, who will be on the hook? You dear taxpayer, that's who.

At our firm we frequently receive calls from clients and readers asking about the likelihood of the passage by the Congress in Washington of reform legislation regarding over-the-counter (OTC) derivatives, financial regulation and/or mortgage securitization. Our answer is small to none given the political trends and the state of the lobbies in Washington, most specifically the large bank lobby that protects the Sell Side monopoly in OTC derivatives and securities. The fact that Senator Richard Shelby (R-AL) is still apparently not comfortable with the entirely watered down House proposal to reform OTC derivatives, for example, tells you all you need to know. Stick a fork in it.

Derivatives trading volumes in January 2010 were stronger, with European derivatives volumes increasing 32.4% and U.S. options trading volumes increasing a whopping 102.4% y/o/y. Cash equities trading volumes were mixed, with European cash transactions increasing 4.1% and U.S. cash equities trading volumes declining 23.7% from Jan '09. Total interest rate products ADV of 2.7 million contracts in January 2010 increased 37.8% from January 2009, and increased 50.5% from December 2009. Total interest rate product ADV is at the highest level since March 2008 !

"With respect to financial market infrastructures, the Federal Reserve is working with a broad range of private-sector participants, including dealers, clearing banks and tri-party repo investors to dramatically reduce the structural instability of the tri-party repo system." - Oh, so it is structurally unstable. All this, and many more remarks of the "I say X, but really mean Y" variety in the attached speech.

While many pundits will obsess over the markets' gyration in this past week, and make it into a major headline in the quest for eyeballs, the truth is that the S&P turning negative for the year was merely a sideshow (the next real market crash will be much more memorable). No - the real story was the advent of Paul Volcker to his rightful place on the, well, right of President Obama, coupled with the now imminent departure of Geithner and Summers, and the massive question mark that now hangs over Goldman Sachs. Who could have believed that the implications of one Senatorial election could be so profound, yet that is precisely the stuff black swans are made of. The new regime is here, and like it or not, it brings with it a new framework of variables. Yet shifting from the past and looking at the future, the question now becomes what should investors focus on? Just who is this Paul Volcker who will now be the President's seemingly primary economic advisor, and more importantly, what will his policies be like? Luckily, an extensive blueprint already exists, and Zero Hedge readers should be quite familiar with it by now.

Recently Goldman Sachs has been attempting to downplay the impact of prop trading on its operations, with various executives, among them both Lloyd Blankfein and David Viniar, claiming that proprietary trading accounts for a mere 10% of total revenue. This is likely a major misrepresentation and a substantial underestimation of the true impact of prop trading to the firm if an earlier analysis by third party credit analysis firm CreditSights is correct. According to CS analysts, Goldman's true prop exposure is at least 30% and probably inbetween 30% and 40%. This would imply that the proposed ban will have a truly material impact on Goldman, much more so than Goldman's executives claim.

With everyone in arms over the prop trading ban, the simplest question has so far evaded the broader population: just what does the administration define as "prop trading." And, as Bernstein points out, will the loophole needed to not crash the bond market be large enough to render the entire proposal moot: "Bernstein would guess that the wording of "operations unrelated to serving customers" in the Administration's release may be related to primary dealers in government bonds that must take on market risk to remain profitable when dealing with clients in the Treasury market. With virtually no bid-offer spread, proprietary trading exemption would be necessary for the government desks. But we find it hard to believe that the new proposals are meant to allow unlimited risk taking in high yield, derivatives and emerging markets desks as these desks make a market for its clients. Unfortunately, at this point, nobody knows exactly what the limitation, or even the definition, will be."

If you accept situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype “problems” that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles.

Chinese GDP is officially in the redzone: at 10.7% YoY, while Q3 was revised to 9.1%. For all of 2009, Chinese GDP rose at 9.7% (2008 came in at 9.6%): China's mystical printing machine helped the country avoid any aspect of the global recession, and these are not the droids we are looking for. At the same time the country announced a 1.9% CPI increase YoY in December, even as 2009 saw a -0.7% decline in CPI, compared to a 5.9% increase in 2008. Retail sales in 2009 surged at 15.5% nominal and 17.5% real.

Another horrific reversal of the "risk-on" / "risk-off" trade today, as investors were spooked over the possible financial implosion of Greece. And in today's "mouseclick" world, hedge fund managers hit the "eject" button and sold anything and everything related to emerging markets and piled into safety assets.

Let’s assume for a moment that Goldman Sachs is wrong. After all, at most points in time and space, predictions tend to fail—except the lucky ones. So it’s good to think through scenarios that one would consider extremely remote. Active risk management means low probability / high catastrophic outcome tail events must be hedged, and as importantly, gain exposure to those pesky Blacks Swans in ways that lead to advantage. To accomplish this, it helps to obtain a quantitative sense of their impact, to get a “feel for the cloth” as an wise former boss of mine used to say. So let’s try here.

What if the Fed more than succeeds in reflating and the end result is hyperinflation? As remote a possibility as I think this is, they really could print a way to another, completely different type of economic destruction. All they have to do is print proactively, not reactively.

- New Study Analyzes The Bill’s 200-Plus Pages Covering Derivatives, Outlines Potential Industry Impact And Gives A Timeline Leading To US Senate Passage
- Says New Competition Lies Ahead For Dominant Major Dealers From New Group Of Smaller, Nimble Tech-Savvy Dealers

So... Timmy... Who's lying here?