JP Morgan and Goldman Sachs to design “new generation” derivatives

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( – ‘The two largest investment banks in the world, JP Morgan and Goldman Sachs, have joined to take another step forward in the process of financial innovation. These two banks are developing new types of derivative instruments more sophisticated and with complex systems of valuation called “new generation”.

These new derivatives will be based on exchange contracts with collateral (swaps) linked to a price index of speculative grade loans (equivalent to junk bonds) called Markit’s iBoxx USD Liquid Leverage. This index is the benchmark of the “leveraged” loan market which has a capitalization of USD 750 billion, Morgan Stanley said in a report. This method, known as “indexing” somehow neutralizes the risk for those who want to continue leveraging.

Meanwhile, Goldman Sachs has prepared an issue of EUR 10 billion (USD 13.4 billion) of structured bonds based on paper with higher returns in the category “securities” such as mortgage bonds (also known as ABS, asset-backed securities). In recent years, Goldman has been one of the most active banks creating new financial products.

J. P. Morgan and Goldman Sachs are not alone in this process. For example, ProShares has started to offer to its customers an Exchange Traded-Fund (ETF) in which its assets are backed on CDS of corporate debt. CDS stands for Credit Default Swaps, a  insurance contracts against default, in this case, against corporate bonds default.

In the era of extra-easy money provided by the Central Banks and the sluggishness of  main sectors of the economy, financial professionals are seeking new ways to achieve returns to beat the market. To do this, they have to take more risk, which is represented dramatically in derivative contracts.

Since 2007, the most daring investors who trusted debt instruments like “high-yield” assets have reached 145 per cent on average revaluation of its portfolio. Given this “rally”, analysts wonder if we are now at the top and, therefore, we are again on the brink of a new slowdown in financial markets. As Lawrence McDonald, chief strategist at Newedge USA points out: “At the peak of the market in 2007, there was all this kind of innovation and many investors did not realize it on time. These products were a clear indicator of risk. ”

In recent days, many market analysts are taking historical charts to warn of a new bear market. However, there have been strong structural changes in the market that stops the possibility of an overnight strong slowdown. The foundations of economic recovery are not solid, there is a distorted perception of risk and Central Banks continue conditioning the economy. These three factors interact at the same time, working in opposite directions. At the moment, the excess of liquidity is winning the game.


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Javier Santacruz Cano

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