In Defence of Derivatives

Reason has a great article In Defence of Derivatives by Gene Callahan and Greg Kaza, which goes into great depth explaining the source of the hysteria that we’ve seen after the Enron debacle about derivatives.

In the season of finger pointing that followed, derivatives trading was singled out for abuse. “If you dig deep enough into any financial scandal,” BBC business reporter Emma Clark claimed in February 2002, “you can usually find a derivative or two to take the blame.” Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as “the most toxic element of the financial markets today.” Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. “We view them as time bombs, both for the parties that deal in them and the economic system,” Buffett wrote in his 2002 annual report for Berkshire Hathaway. “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

The fact of the matter though is that derivatives solve very important problems for businesses big and small. I’ve always been a fan of derivatives as it really is a beautiful freemarket approacht to solving a whole range of problems, that would otherwise have to be solved by further government burocracy.

The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.

The article mentions that derivatives really arent anything new. Apparently the Greek philosopher Thales bought options on olive presses during times, when he speculated the olive season would be good. Also derivatives were popular traded instruments in Amsterdam in the 1600s, which I have just been reading about in Neal Stephenson’s latest book Quicksilver, where one of the characters is heavily into speculation on this market.

If we accept that derivatives have good reasons, then we must accept as well that derivatives need speculators. Because if not, there wouldnt be anyone to absorb the risk that we are trying to avoid. Let speculators who specialize in currency risk deal with the risk.

This is where we get to real misunderstanding of derivatives. Many people will say that derivatives have no real (intrinsic) value:

bq.As the above description indicates, derivatives can be tricky to explain. Although they have been around for decades, are widely used, and have many valid commercial applications, they have an undeniable image problem. In the wake of the Enron debacle, The Washington Post described derivatives as “complex, risky and largely unregulated financial contracts.” The Baltimore Sun quoted Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, as declaring: “Derivatives, when used speculatively, amount to nothing more than gambling.” Even Linda Davies, author of the Bowie Bonds novel, argues that “derivatives are financial instruments that have no intrinsic value.”

The first problem with Davies’ complaint is that no goods have “intrinsic” value. The value of economic goods arises from the desire human beings have for them; it does not somehow reside in the goods themselves. Perhaps the novelist means that while stocks and bonds, for instance, are truly valuable to their owners, the value ascribed to derivatives is somehow less real. But such a complaint will not stand scrutiny.

Hello!!! This is economics 101. If something has value to you or anyone else then it has value!!! This is very simple. Whether you use Black Scholes or your gut feeling to value it, it has value. You would only buy it if it to you has a value higher than the current market price.

The article then continues to analyse what the authors believe is the real source of most of the large problems highlighted by Enron, Worldcom and most of the other large scandals. They believe the regulators unintentionally cause most of these problems, by two main regulatory actions:

• Safeguards
• Bailouts

Basically in the case of Enron their “dubious accounting” was really caused by focusing on getting around the legal safeguards. Many companies have official external financials and real internal financials. This is caused primarily by regulators, creating an environment where companies have to “comply” regardless of the real facts. Thus new types of derivatives spring up to serve the purpose of hiding problems from regulators.

Partnoy notes that many of Enron’s dubious maneuvers involving derivatives were designed to enhance the company’s “accounting reality” at the expense of its true economic condition. But the divergence between accounting and economic reality is itself chiefly a product of the regulatory environment in which publicly traded companies exist. The existence of legal “safeguards” to protect the investing public encourages companies to focus on the safeguards at the expense of the actual financial health of the company. That does not excuse the behavior of executives who violated their responsibility to shareholders, but the motivation to do so would not have existed without regulations that create a divergence between economic reality and accounting reality.

After this, the regulators create a history of bailouts and safety nets, which essentially encourage people to take more risks. I believe that if a company/bank/fund or whatever fails, they should never be bailed out. It serves no one any good. The economy will bounce back and be more stable afterwards.

Then there is the question of how to clean up after a derivatives meltdown. When, after some gamble has gone horribly wrong, the government intervenes to soften the blow to investors, it creates a moral hazard. Once people expect that someone else will pick up some of the cost of their speculative failures, they are more likely to undertake risky actions than they would if they had to bear the cost themselves. The amateur mountaineers who venture into places they would never go if there were no park rescue services are a case in point — the existence of a free rescue service prompts people to take risks they wouldn’t otherwise, necessitating even more rescues.

Anyway it is a very well written and well researched article, that anyone that says “Something should be done about ….” should really read. Derivatives are here to stay, even if the regulators try to limit them. They will just spring up in new forms, as they should.