FinReg for Dummies: derivatives

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If I hear the term ‘complex financial instrument’ without any further elaboration one more time, I am liable to throw something at the television. I wish that I could use my Wii remote to launch tomatoes at news anchors who seem to believe their motto is, “We report. You go look it up.”

How can we possibly think we stand a chance of adequately regulating the financial sector when no one can even explain exactly what it is we are regulating?

The most blatant example of things-we-should-fear-but-need-not-understand is derivatives. Given the scarcity of descriptions that go beyond, “they’re complex,” I imagine you’d be hard-pressed to find one non-banker that can explain them.  Yet they are central to this regulation, so let’s try to break it down.  Deep breath…

A derivative, at its most basic level, is a financial instrument that derives its value from another asset, hence the name. There are various types of derivatives – options, swaps, futures, etc. – but they all share this common trait; they cannot exist without the presence of some other underlying asset.

In contrast to what Congressional theatre would have you believe, derivatives are fundamentally valuable to the process of mitigating risk. The easiest way to explain this is through commodity futures, a type of derivative that allows someone to buy something tomorrow, at a price determined today.  Many businesses could not survive without these arrangements.

Take orange juice futures, with oranges being the underlying commodity.  If you are an orange juice producer, the sustainability of your business is highly susceptible to the price of oranges.  So if you are worried that Florida might have some of the coldest temperatures on record, as it did this past winter, you might be willing to pay a fee lock in a price, just in case.  Because if the frost settles, and the orange crop yield is cut in half, prices will go through the roof.  Your gross profit margin will drop and you may fail to recover all of those fixed operating costs.  Without a degree of certainty, no OJ producer would make the investments necessary to get from harvest to glass.

Orange juice producers thus use orange futures to protect against the uncertainty of the weather.  All the other derivatives, no matter how complicated, are similarly used as protections against uncertainty in the underlying assets.  CEOs are paid in stock options because shareholders are not certain management will increase the value of the underlying stock.  Businesses that invest in other countries use currency swaps to protect against uncertainty in the value of the underlying foreign currencies.  Banks use interest rate swaps to protect against fluctuations in underlying interest rates.

But if derivatives are so important to the process of mitigating risks, why are they most often associated with speculation?  The fact of the matter is that for derivatives to do their job of mitigating risk, someone has to take the other side of the bet.  Our orange juice producer cannot protect against his uncertainty without someone on the other side willing to bet that it will be a perfectly normal winter.  It’s all speculation, but one person’s nay-saying is another person’s insurance.

As you likely have heard, credit default swaps were at the center of the financial crisis.  They are very similar to insurance, in that they pay out to the buyer in the event of a negative outcome.  Their good side is that they allow lenders to insure themselves against the default of their borrowers, but again, the counterparty tends to put us on edge.  Whoever takes the other side of that bet is essentially speculating that the borrower will default.

But when we talk about regulation, the issue is not the speculation, it is transparency.  Most derivatives are not traded on public exchanges, but instead are traded “over-the-counter“.  What this means is that no one aside from the two parties involved in the trade know the terms of the trade, which is where we ran into problems in the financial crisis.  In the absence of the transparency seen on public exchanges, no one understood who was exposed to who or how a domino effect of defaults could tear through the economy.

This is why getting derivatives regulated on exchanges is so important, because it could actually help stave off crises by bringing all the relevant information to light and allowing for some insight on future risk.  One of my finance professors used to say, when vacationing in Florida, he would take changes in the price of orange juice futures over the weatherman’s forecast any day.  Sure enough, orange juice futures shot up in the days leading up to those unusually cold days in Florida.

The argument that has been made is that, if more derivatives had been openly traded, we would have had a much greater understanding of the risks facing the housing market.  If Paulson’s bets against the housing market (the ones at the center of the Goldman Sachs fraud case), had been more transparent, other investors would have picked up on his insights.  As more and more followed suit, investors would have become much more skeptical of the housing boom.

In Congress, both sides of the aisle seem far too ideological on the topic.  Democrats would love to limit derivatives trading, but that ignores the value they hold for individual businesses as well as their potential to foreshadow risks.  Meanwhile, Republicans pretty much don’t want to allow any regulation of anything, and have been particularly protective of derivatives, likely because over-the-counter currently earns their supporters higher fees.

The central plan of the bill is to get all derivatives onto regulated exchanged, and all trades to go through a central clearinghouse to assure investors have enough capital to cover their bets.  To me, that sounds good.  Any efforts to reach beyond that will limit the benefits derivatives offer.  Any efforts to keep certain derivatives off these exchanges will increase the risks of limited information.

I find that I like my financial sector like I like my democracy: all-inclusive, because more information is better.  The more trades that pass through a central clearinghouse, the more we are able to deal with problems of uncertainty.

Perhaps there’s a derivative for that.

Posted on May 15th 2010 in news

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