I don’t watch much television news. But when I catch a glimpse these days, it always seems as if some politician is loudly declaring the need for more governmental financial regulation.
Mostly, the politicos contend that financial derivatives are dangerous instruments that are contrary to sound public policy. We have to protect those poor souls who bet against John Paulson, don’t you see?
But the proponents of this view simply do not want to understand the nature of derivatives, just as most of the same ones didn’t want to understand the valuable nature of the risk management of natural gas prices that Ken Lay and Jeff Skilling contributed to markets 20 years ago.
Derivatives are simply a way for an investor to warn by trading – that is, by putting his money where his mouth is – that he has information about an upcoming shift in the markets. That facilitates a transparent and well-informed marketplace.
However, heavily regulating traders from taking advantage of that valuable source of information only makes it more difficult for valuable information about market shifts to reach the marketplace. How is that good for investors seeking as transparent and well-informed marketplace as possible?
An underappreciated cause of the Wall Street crisis was the underlying information failure. As opposed to restricting trading, we ought to be finding ways to bring more information to the market faster so that prices can be adjusted promptly.
Rather than demonizing folks who bet their money in bringing information to the marketplace, we ought to be encouraging them.
I won’t hold my breath waiting for that to happen.
“Derivatives are simply a way for an investor to warn by trading ñ that is, by putting his money where his mouth is – that he has information about an upcoming shift in the markets. That facilitates a transparent and well-informed marketplace.”
More precisely, derivatives are a way for an individual to define a specific risk and to refine their exposure to that risk. In the instance of credit default swaps, the risk is the inability of the borrower to repay the debt. One could short the actual debt issue, but the actual debt issue also carries with it interest rate risk. The interest rate futures contract would allow one to hedge the interest rate risk and the CDS parses out the credit risk.
We may or may not have enough information on how specific risk components will perform in various market conditions. This is especially true as we parse out more narrowly defined risk parameters. Hence, certain derivatives may not perform in the marketplace in the same manner in which they are theoretically modeled.
That being said, disallowing market participants from defining specific risks in their portfolios and then refining their exposure to those risks should be a topic of public discussion amongst policy makers. Simply declaring derivatives as the work of the devil is not productive or helpful to the marketplace as a whole.
Tom:
Obama’s magic number is 3%! So we don’t need any derivatives.. LOL!