Why don't they make an exotic product prop shop?
I know this question is really dumb, but I'm curious. Why don't they have proprietary trading firms to trade exotic products? By structured products, I mean structured credit products (CDOs, CLOs,CMOs, and other ABS), energy derivatives (swaps, forwards, linked notes, etc), and interest rate derivatives (I know this isn't structured) like(swaptions,Turbos, Snowballs, etc). I know that liquidity is a major issue in trading exotic derivs like the ones mentioned. Intellect is an issue as trading exotics requires more 'skill' than equities. What else do you think prevents a exotic product prop shop?
Just about all of these products are traded OTC, so there is less transparency, less liquidity as you mentioned, and I could be wrong about this part, but I think a lot of these products are still traded over the phone. Since most of these firms have a competitive advantage in technology, they would lose this edge if they moved into the exotic space. That being said, a part of the OTC market is starting to be captured by exchanges, especially CME, so it is possible that once CME makes more ground, you could see some firms start to move into the exotic space, this last part is just an educated guess though.
very insightful view by above poster. i work closely the dcm and agree with just about all points regarding derivs except that i don't see many players entering the exotic space in the near future given the market climate associated with the structured vehicles that started this mess in the markets. it's stupid really, but the fact of the matter is risk management won't see expansion into anything related in the short term.
They don't have the balance sheets to make markets in these areas?
counter party credit risk among other reasons mentioend above far too many barriers to enter these markets
You also need to keep in mind who is the market for structured products. Some exotic products, like a commodities basket option or a principal-protected note on a basket option, for example, are usually geared towards investors, who are buying and holding (real money investors, for example).
Other products are bespoke hedging solutions geared toward someone with an underlying exposure (so in commodities it would be a corporation like P&G or Southwest), but again, someone who is also looking to buy and hold. For corporates the hedging solutions are so structured that they would be of no use to anyone but the intended client. As a result, there's really not much in the way of secondary trading of most structured products. Hence, few people actually "trade" them.
That's why at banks the sales people and structurers are the ones who are most active in structured products, whereas the traders are usually just hedging out the risk involved in structuring and selling structured products to clients.
http://www.afr0jacks.com/ Afro Jacks
CME has already started to capture part of the OTC market in derivatives, albeit a very small portion. There is an article about it in Bloomberg Magazine from a couple months ago. CME is a very innovative and well-run exchange, so I could definitely see them gaining more ground within the OTC.
http://www.afr0jacks.com/ Afro Jacks
...because no one would know what was going on.
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