042510 Swapping the Risk of Fault

Swapping the Risk of Fault

Today I researched derivatives to see if they could be done away with altogether. So far I’ve found that those who support the existence of derivatives do so for two reasons: first they claim that derivatives are useful in helping with “price discovery”. A futures contract with the nearest expiration date is taken to best determine the price of a commodity. Thus a derivatives contract on a commodity is a way of distilling all of the knowledge and “expert opinion” about a commodity into a price.

The second benefit of derivatives is said to be that they function to manage risk. To take a risk on a stock or a commodity an investor can simply buy the stock or buy a futures contract on the commodity. If he wants to avoid being fully exposed on the downside, he can buy a derivative to hedge the risk. Of course he could buy “puts” on stocks to accomplish the same thing. But if he wants to bet on a stock index like the Dow Jones Industrial Index it would be simpler and cheaper to buy a derivative rather than buy a variety of stocks. So a market in derivatives makes the market more efficient by allowing the investor to buy a single instrument which in effect bets on the direction of the market rather than having to buy a variety of stocks and pay the associated commissions. Incidentally it allows the investor to leverage his money because he is simply betting on the profit or loss in the market rather pay the full value of each stock. Thus the purchase of a derivative is a real convenience.

Because of the Great Recession some are looking for a way to curtail the excessive risk that many big banks took by creating and selling derivatives. One way would be to only allow a trader to buy derivatives to the extent that he (the individual or institution) owned the stock or commodity —or owned a futures contract to buy the commodity. This rule would not be intended to eliminate the convenience factor of derivatives mentioned above. Rather it is intended to reduce the total amount of risk that a trader could take. Speculation or betting on the market without actual ownership of a stock or commodity would be prohibited. Derivatives could only serve as insurance on a trader’s risk, i.e. as a hedge against devastating loss. Hedging against risk is a legitimate practice, just like taking out insurance on your spouse to protect against the financial consequences of your spouse’s untimely death. But it is not legitimate to take out life insurance on a stranger. I sure wouldn’t want some stranger to be in a position to make a lot of money if I were to suddenly die. I’m not a paranoid person but if a couple of neighbors took out big policies so they would profit handsomely from my untimely death, I could get paranoid pretty fast. Insurance laws have generally required that someone have an “insurable interest” in order to buy a life insurance policy.

Would such an arrangement, prohibiting betting on the market when you don’t own the stock or commodity involved, harm the market? Currently derivatives and similar instruments account for big profit centers within large investment firms. In the short run those firms would be harmed by losing those profit centers. But in the long run would the financial markets be any worse at serving their essential purpose? I doubt it.


The basic question I am left with is whether the market would be better off if we did not allow derivatives except to the extent that a trader owned the underlying asset. I believe that the markets would not be fundamentally damaged despite some short term ripples caused by the reduction or elimination of the profit center now provided by derivatives and similar financial instruments. Another side effect might be that the size of the financial sector could shrink. As the best and brightest brains have gone into banking and developed very tricky and complicated financial instruments, and made a lot of money, have those brains really been put to a good use for society at large? Economist Paul Krugman said that when financial experts are asked to name a financial instrument developed in the last 50 years that has clearly helped mankind, they are unable to name one. If those best and brightest brains in the future become scientists, doctors, physicists and engineers might not the future be a different story from the present?

So I am inclined to want to return to the days when banking was simple, narrowly focused and banks were not allowed to be involved in investment nor in the buying and selling of risk that essentially is gambling. My position on this subject is not rigid. I know that I am no financial expert and the world of finance is sophisticated. I could be convinced otherwise if information came my way indicating that derivatives are a good thing. But there has been a Great Recession and many knowledgeable people believe that the unregulated derivates market is partly responsible. Thus unless the derivatives market is changed it continues to pose a risk of the same thing happening again. So to convince me that derivatives are a good thing I would need to be convinced that their value balances the risk they pose to individual firms and to the global economy. At this point they must be considered on the defensive. It is incumbent on their supporters to prove their worth rather than on their critics to prove their lack of worth.