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The over-the-counter markets are back in the spotlight this week with the news that Goldman Sachs used them for a series of currency swaps which helped the Greek government understate just how deep in debt it really was.
They were also centre stage last month when a key part of the regulatory proposals drafted by former US Federal Reserve chairman Paul Volcker for President Obama was for all OTC trades to be run through a clearing house so that they would become visible and could then be monitored by the authorities.
They were in the news last year and the year before because they were where all the subprime products were developed and marketed. They also affect the everyday world outside the financial community.
Gary Gensler, head of the US Commodities and Trading Commission, told Congress last year in support of his request for more regulatory powers that “on average a $50 tank of gas could have as much as $1000 in derivatives behind it”.
These mentions are therefore just the tip of the iceberg. The OTC markets are where the bulk of the world's financial business is done.
They are the investment bankers' real playground, and home to vastly more financial activity than takes place on the recognised stock and futures exchanges.
But only the participants know what is being done there, and even then they only really know their own slice of the business — which is one reason why, when the subprime crisis erupted, no one knew how much product was out there, what form it took or who was holding it.
Without the OTC markets, we could not have had the financial crisis in the form we have.
Market participants say it is obvious where Volcker is coming from but the flaw in his plan to create more disclosure and transparency, and it is a big one, is that it assumes that the information thus generated will be true.
However, those who regularly use the OTC markets say that the real problem is that deception and outright fraud is endemic.
Too often, the price at which a trade is reported is not in fact the price at which the deal was done. Too often, the counterparties who appear to have done the deal are not the only people involved.
Better reporting and monitoring by using clearing houses could therefore make things worse if they provide regulators with the false comfort of false information.
The act of disclosing a trade tells you little about the quality of that disclosure or the integrity of the underlying bargain. A market is not 100% clean just because it is 100% reported.
Something more than disclosure has to happen before the OTC markets generate a level of malpractice that threatens seriously to undermine their credibility.
One participant described what was going on as potentially bigger than Enron — scope for another musical perhaps.
Although the markets and their products are complex, the fiddles are relative simple. Although there is no supervised or regulated source of pricing for OTC bargains, some prices are posted on Reuters by the independent third-party dealers.
The complaint is, however, that there is collusion between these “independent dealers” — the OTC brokers — and the traders inside the banks to fix the reported price to their mutual advantage, and without the knowledge of their higher-ups.
They do this because such prices are used by the banks for their internal portfolio valuations (and calculations of entitlement to bonuses) and for setting swap rates on deals running to hundreds of millions and sometimes billions of pounds.
The other complained-of scam is that sometimes “acquisition from a third party” is required to make a trade work, and in these cases the bank trader will use an agency broker to “buy” a position and “sell” it back to him despite the fact the broker has no regulatory capital in place to support it acting as a principal.
But they usually get away with it except on those rare occasions when someone loses his job halfway through a deal, or gets cold feet, or there is a settlement query that brings the transaction to the attention of outside eyes.
It is no coincidence that this sounds terribly like what Bernie Madoff got up to in running his $50 billion hedge-fund fraud.
It is doubtful whether any outside regulator could get deep enough inside a firm to weed out this activity. What regulators could do, however, is lay down a broad regulatory framework within which institutions would be encouraged, by investor and customer pressure, to raise their game.
A key part of this would be much more stringent audit requirements that would require a large random sample of trades to be checked regularly to ascertain that the price was fair, that there were no suspiciously large volumes or concentrations of activity with unlikely third parties, or that the trades were not structured in a way which implied that their main purpose was tax evasion or money-laundering.
Applying procedures with real bite across a limited range of fronts could make a major difference in setting the tone for internal quality control within financial institutions. It needs to happen sooner rather than later.
