Last week I attended the Futures Industry Association (FIA 2011) trade show in Chicago. Along with our partners in crime Numerix, Sybase and the folks from Panopticon we spent two days chatting about Risk Analytics, Complex Event Processing, Derivatives, micro-breweries, Wall Street protesters and sushi. Time well spent.

After several visitors to our booth expressed an interest in real-time derivative pricing, someone brought up the credit crunch issue and how much of it may have been based on improper derivative pricing. Collateralized Debt Obligations (CDO) and their faulty valuations have certainly been at the forefront of the debate, prompting the New York Times to print a scathing coverage of the issue, appropriately titled "How Wall Street Lied to its Computers". That got my wheels spinning. When it comes to complex, cross-asset derivative pricing (ie. CDO, Swaps or Milti-Legged Options) only a hand-full of large financial institutions can afford to invest in a large in-house quant team that can provide the proper pricing services. And in many cases the organizations that price such securities are also the market makers for those securities.

Since the rest of the financial industry relies on those prices (set by the market makers) to be accurate in order to properly valuate risk and opportunuty, it begs the question.  Does owning the pricing services constitute a price monopoly?  We beleive it does.  The problem here is that pricing and valuation models are considered intellectual property, the so called 'secret sauce' of a financial institution and are therefore not subject to anti-trust laws the same way other monopolies are.  As such, the bigger question is whether an Open Derivative Pricing platform can solve the problem? Is Pricing as a Service a possible way to harness the wisdom of crowds and assist in self-regulation of the derivatives market?  Can crowd sourcing result in more accurate risk models (based on a price equilibrium) and resolve the price monopoly stale mate?

A few years ago Alan Greenspan gave a speech at a Sybase/NYSE event in New York where he basically said that the system they though was self-regulating really wasn't. And that the Frank/Dodd Act was an attempt at bringing structure to an otherwise unregulated market.  This seemed like a bit of a cop-out because in the end, the US government cannot appoint (or afford) to employ teams of quants and statistical analysts that would enforce Frank/Dodd or the Volker Rule.  The government once again, assumes that banks will be 'honest' and regulate them selves, whereas the banks incentive is to withhold information about pricing and use it as leverage. Since banks have a virtual monopoly on price setting, and there is no way to force regulation (forcing banks and hedge funds to divulge their pricing models is beyond the powers of the FED), it is not possible to foster coopetition.

Perhaps I am wrong, but it seems that derivative pricing (which is it self a product) is 'expensive' and few alternatives exist.  Pricing typically occurs in a vacuum and there is no possibility of a second opinion.  As long as banks don't price (complex) derivatives in an open forum (and continue to consider black-box pricing strategies an advantage) the derivatives market is over exposed to a repeat of the crisis seen in 2008.  The key here is to chnage the bank's incentive and thereby change their behavior.

So what if we open up that game and make Derivatives Pricing a service that is affordable and accessible to many smaller trading firms? Harness the wisdom of crowds and thereby bust up the pricing monopoly.  Wouldn't that reduce cost and increase accuracy resulting in a price equilibrium?  Wouldn't the market then again, self regulate and wipe out the monpolistic advantage of big banks?  Disruptive.  But probably all the more reason to do it.