Tuesday, 30 June 2009

Pray Tell Me, Are Derivatives Good or Are They Bad?

For the past 30 odd years, derivatives have acted as the barometer of popular sentiment toward markets. In good times, they are praised as ingenious inventions that allow companies to save money in their finances. In bad times, they are scorned as the mysterious devices created to game the system. At all times, they are not understood. The level of discussion never goes beyond the derivatives-are-good/derivatives-are-bad platitudes.

This appalling insubstantiality is in full display again in the latest round of talks about the regulation of markets that, naturally, involves derivatives. In its latest research paper, the Bank of International Settlement likens markets to “pharmaceuticals” and argues that more potent drugs – that would be derivatives – should be made available only by prescription. (The analogy cannot be carried any further because that would imply that only very sick companies could use complex derivatives.) Sage of Omaha is on the record with this gem of a thought that derivatives are the “financial weapons of mass destruction”. George Soros thinks that some derivatives are good and some are bad and should be outlawed, exactly the sort of penetrating analysis one would expect from a money manager who wants to be known as an intellectual and a philosopher.

This past Friday, Floyd Norris of the New York Times picked up the subject. “In the world of derivatives, profit for dealers comes from complexity and secrecy.” After that dramatic lead sentence, he went on to assert that “even when derivatives do allow financial risks to be transferred, that is not always a good thing” because, he quoted a finance professor, derivatives in fact “shift risks from those who understand them a little to those who do not understand them at all.” Norris is among the more perceptive of the business reporters.

Speaking of those who do not understand derivatives at all, here is what I wrote in the opening paragraph of the Foreword to Vol. 2 of Speculative Capital:
Derivatives are the functional form that speculative capital assumes in the market. This form is fundamentally a bet. But like the bodies of the damned in Inferno whose deformity corresponds to the sort of sin they have committed, the particular composition of each derivative corresponds to the sort of opportunities that speculative capital intends to exploit. Arbitrage opportunities are many and varied; hence the confusing array of derivatives and the tortuous legal documentation that must accompany each.
I then added:
The subject of risks of derivatives is a virgin territory. That is not due to the dearth of attempts to exploit it. Quite the contrary; the mountain of material on the subject has few rivals in any discipline. But the territory of concern to us is in the realm of theory and thought, into which unthinking material cannot penetrate no matter what its size.
These lines were written over a decade ago. They remain as valid now as they were then.

Meanwhile, the crisis goes on.