Creditflux Newsletter

Former Fed chairman Paul Volcker was half right when he told a conference last month that the ATM was the pinnacle of financial innovation, and that nothing useful has been developed since. He was probably thinking about CDOs, but there are plenty of other products that compare unfavourably to ATMs.

The wonderful thing about hole-in-the-wall machines, as they are called in the UK, is not just, as Volcker pointed out, that they meet a real need. They are also simple devices that use open standards.

The tragedy is that innovation in the retail and corporate banking world seems to have stopped in 1968 with the development of the ATM. Nothing else in the world of payments – especially in the US – is simple or designed with the customer in mind. US banks are incapable of making electronic payments (at least not to publishing companies in the UK) and still insist on issuing cheques. In all countries, payments take days to settle and require a bewildering array of references.

In wholesale finance, by contrast, there has been rather a lot of innovation since 1968. And, as in any industry that competes on product development (think of pharmaceuticals, mobile phones or cars), innovation has been a mixed blessing.

The bad part is that many smart people have spent a great deal of time thinking of schemes to circumvent bank regulation and ways to arbitrage ratings. Structurers and rule makers have been engaged in an innovation arms race in which the ratings methodologies and bank capital regulations become ever more complex and unwieldy as the bankers find new ways of getting round them.

This has resulted in the creation of entirely spurious products, such as SIVs and leveraged super seniors, and unnecessary industries, such as monolines and commercial paper conduits.

We are pleased to say that both rating agencies and regulators have now seen the error of their ways and have thrown out their complex formulae in favour of rules that work on broad principles. Only joking. The Basel Committee is working feverishly to add extra layers of complexity to its monstrous creation, Basel II, which will only encourage a vast new industry of bank capital optimisation. Politicians look set to impose complex rules about what traders and other bankers can earn, which will foster the growth of a new “compensation structuring” industry. And the rating agencies continue to do business in a way that begs banks to outsmart them.

But let’s not forget that some innovation in the credit markets has been of the good sort. Credit default swaps and standard credit indices are the perfect examples. They provide a standardised and simple way to trade credit risk, which is one of the most fundamental uncertainties of economic life.

If, 20 years ago, a Mexican cement company had sold a bond, investors would have had little idea of its creditworthiness. But when Cemex came to the market last month, the growth in transparent and simple credit-trading instruments ensured that a thousand firms around the world had informed views about its credit standing. That provides a clear benefit to the economy as a whole.

Credit products continue to be torn between two paradigms: one is opaque, non-standard and highly optimised; the other is simple, standardised and transparent. Until now, CDOs have fallen into the first category. But as we look to the re-opening of the markets for CLOs and CSOs, this is a great opportunity to recreate these powerful products. CDOs can and should be standard, transparent and simple. Rather like ATMs, in fact.