The Warning, "Swallowed by the London Whale"

In class this week we watched the PBS production The Warning, which focused on the lack of regulation on Wall Street, particularly in the area of over-the-counter (OTC) derivatives. We also read the New York Times magazine article, “Swallowed by the London Whale”, which showed how investing in these OTC derivatives negatively affected JPMorgan and Chase.

As defined by the International Swap Dealers Association (ISDA), a derivative is a risk transfer agreement in which the value is determined by the value of an underlying asset. This underlying asset could either be an interest rate, a physical commodity, a company’s equity shares, an equity index, a currency, or any other tradable instrument parties can agree upon.

Derivatives fall into three categories: OTC, listed derivatives or futures, and cleared derivatives. An OTC derivative is negotiated privately between two parties and then booked directly. OTC derivatives are private swaps that take place in secrecy. As we saw in The Warning and in the New York Times article this posed a huge problem for investors. Even though OTC derivatives appeared to be a good investment, investors did not have all of the facts and ended up taking on too much monetary risk without fear of consequences. An open market is key to trading in order for investors to make knowledgeable and responsible trades. However, this wasn’t - and still isn’t - the case. Instead what remained was an accepted belief among investors that the markets were honest. Wall Street had too much freedom and they took advantage of that freedom which cost many companies and banks a lot of money.

There are many different views towards the regulation of Wall Street. People like Alan Greenspan believe government intervention in the markets will hurt the markets more than help them. This means sometimes allowing companies to fail in order for them to learn from their mistakes. Greenspan and his followers remained adamant about blocking all forms of governement regulation, including fraud. The then chair of the CFTC, Brooksley Born, had a different opinion. She looked heavily into OTC derivatives and saw how detrimental that time bomb would be if it went off.

Born uncovered the massive amounts of money flowing into and out of these OTC derivative trades and the lack of transparency within these black boxes. She was fearful of how risky these trades were and how much money they were handling. When the OTC derivatives market reached $595 trillion, Born was forced into action despite the resistance of big leaguers like Alan Greenspan. She petitioned for more regulation but unfortunately no one headed her warning and Born resigned.

JPMorgan and Chase is just one example of secret trading gone wrong. The company lost $6 billion dollars because they were taking great risks without completely weighing the consequences of those risks. However, blame is not to be placed purely on JPMorgan. Markets were holding back key information that investors at JPMorgan overlooked.

I believe some middle ground needs to be met. Greenspan's belief makes sense, but it does not account for human emotion. When people are given too much power, especially when it comes to money, people can get greedy and selfish. Companies do need to take some risk in order to receive reward, but they cannot effectively take those risks without all the facts. It would be like throwing a dart at a dark board you've never seen with your eyes closed.