Options have a future - The Economist

rivatives

Options have a future

Nov 12th 2009

From The Economist print edition

Economies need derivatives, but reform is justified

KING HAMMURABI of Mesopotamia regulated the use of derivatives almost 4,000 years ago. The Japanese have been trading rice futures since around 1650. That contracts based on the price of some commodity or asset have been around for about as long as mankind has been trading indicates that they are pretty useful.

Derivatives enable individuals and companies to insure themselves against risk. Just as they fear the destruction of their belongings by fire or theft, businesses may also be concerned that exchange- or interest-rate movements may turn a good idea into a lossmaker. Derivatives allow them to lessen that risk. But someone needs to take the other side of the bargain, and that usually requires a speculator. Some of those speculators will go bust. Those who insure against fire and theft can set premiums on the basis of decades of experience; financial markets are inherently less predictable.

In the latest crisis, the problem was that investors erroneously believed property prices were quite predictable and built a whole edifice of derivatives on the back of the American housing market. To make matters worse, regulators wrongly believed that the use of derivatives, and the bundling of property loans into securities, had spread risk evenly throughout the system. They accordingly allowed banks to gear up their balance-sheets to a greater extent than before. In fact, much of the risk of a property crash still resided in the banks, and the complex nature of derivatives made their exposure very hard to calculate, leading to a loss of confidence in almost all of them.

Derivatives’ tendency to magnify problems has led to calls for regulators to ban some types. Their economic usefulness, it is argued, is far outweighed by their capacity to create systemic risk. Similar arguments were advanced two decades ago, when equity futures may have contributed to the Black Monday crash of 1987 and British local councils lost money in the obscure world of interest-rate swaps.

But after a few modest reforms, equity and interest-rate futures traded without incident, even through the latest crisis. And the same could be true of the more complex stuff. Even the much-maligned credit default swaps have their uses; by allowing investors to separate default risk from the other risks involved in buying bonds, they potentially reduce the cost of capital for business. Nor is a ban likely to achieve its aims. Congress banned onion futures in the 1950s on the ground that speculators were driving the price of the vegetable. The initiative ended in tears: onion prices since have been no less volatile than they were before.

Clearing and present danger

More modest reform, however, is needed (see article). Proposed legislation to encourage the trading of more derivatives on exchanges or through central counterparties deserves support, for it would make it easier to monitor what market participants were doing. Capital requirements need to be increased, so derivatives cannot be used as an easy way for banks to get around restrictions on gearing.

The trickiest issue concerns exemptions for end-users, such as manufacturers. Allowing companies to hedge their risks is the whole point of the instrument. But if the rules favour them over financial companies, trading will tend to migrate towards them, and away from banks. AIG, once the world’s biggest insurer, thought it was making “easy money” by using its strong credit rating to sell protection against credit defaults; in fact, it was digging its own grave.

These reforms may raise the price of using derivatives, but that would not necessarily be a bad thing. When fire and theft premiums rise, those who really need insurance still pay up