Wednesday, April 21, 2010 10 comments ++[ CLICK TO COMMENT ]++

Opinion: Time to start curbing the growth of derivatives

When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done.
— John Maynard Keynes
How dangerous are financial derivatives to societies? I don't have an answer so this is more of a post to make you think and maybe respond.

I have never really worried about the damage derivatives pose to society. My feeling is that the damage won't be that bad because derivatives are a zero-sum game.

I still think that's true but, given how financial institutions making huge mistakes end up running up to the taxpayer, I am slowly shifting my position towards a negative view. I have a bad feeling that developed societies—only they have sophisticated derivatives markets—may be edging closer to irreparable harm.

The Critic Who Was Wrong

Criticism of derivatives is not new. One of the first prominent criticisms I read was from Warren Buffett, writing a letter to some government agency in the 80's arguing against some futures contracts (I don't remember the article but I believe it was an argument against futures.)

Of course, Buffett was wrong...big time! Not only did the government allow futures contracts, it became such a big hit that they, along with options (another type of derivative,) were thought to be the fastest growing securities markets in the last 20 years (I can't confirm this but just saw this somewhere.) In fact, the market routinely assigns higher valuation multiples to exchanges that deal with derivatives, than companies running stock exchanges. Needless to say, Buffett has even started using derivatives (although only in small amounts.)

Is It Really Bad?

There is a big difference between a security like a stock or a bond, and derivatives such as futures or options. The key element missing from a derivative is that you don't have a direct claim on any physical asset. Related to this is the fact that the legal system isn't suited to handle derivatives. There are some interesting cases in the background involving situations where insurance regulators seized companies while not allowing those companies to pay out obligations under derivative contracts (I don't want to go into the details but if you are interested, study what is happening with bond insurers like Ambac and the CDS buyers.)
The other big problem with derivatives is that the economic benefit appears questionable. There is no doubt that derivatives do help businesses to some degree; the controversy is over the notion of what is 'too much.' For example, derivatives definitely help companies, such as oil & gas companies, hedge their income streams by entering into futures contracts that lock in prices. But we are literally at the point where the derivative market is starting to be severalfold larger than the physical market. On top of accusations of market manipulation (although CFTC has position limits,) do we really want so much capital sloshing around in a financial market larger than the underlying physical market? Do we really want so many workers spending their lives overseeing a "virtual" market?

I also see a flaw in that, a typical derivatives market can literally be any size. Two people can pretty much enter into as many derivative positions as they want. No wonder we have banks with trillion-dollar (gross) exposure to derivatives (net exposure is smaller but still large.) In contrast, stocks and bonds typically have limits. Even the biggest stock market bubble ends up being naturally-limiting.

Keynes Was Right

Some of you aren't fan of John Maynard Keynes and will probably disagree with this, but I think he was absolutely right. Keynes once remarked that, "When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done."

Many, especially on the right or those who are libertarian will disagree with that thinking, since it conflicts with the notion of a pure free market. As far as I'm concerned, I think the pure free market is just as prone to failure as a market run entirely by the government. What we have now, at least in countries like America, is a system where capital allocation is being done less by owners (investors/shareholders) and more by speculators (such as derivatives investors.) As I alluded to above, what does it mean when the futures market in a commodity is much larger than the commodity market itself?

If you think I'm being overly critical of derivatives purchasers, ask yourself this: have you ever met (or read about) a derivatives buyer who cared about the long-term future of the company they were investing in? How many care about the company or underlying asset beyond 2 or 3 years?

The Critic Who May Be Right

One person who has maintained his critical view of derivatives for years is Charlie Munger, Buffett's long-time business partner. In an essay penned in February for Slate magazine, "Basically, It's Over," Charlie Munger presents a harsh criticism of the current state of financial regulation in America. In fact, it's so bad that he ends his essay with a prediction of total collaspe of USA.

I think Munger does a good job of highlighting the major issues blocking better regulation. In particular, vested interests—this includes some readers of this blog who likely owe their jobs to derivatives—will fight tooth & nail to maintain status quo. The worst thing is that the derivatives market is sooo profitable. No wonder everyone and their pet dog in the financial district had their hands on CDS contract of some sort.

Modern Day Bucket Shop? Nay or Yea?

I covered this before but to repeat, Charlie Munger is so critical of certain usage of derivatives that he equates it to bucket shops from the early 1900's. Bucket shops, for those not familiar, were shut down by the US government. Well, the question is, are the present derivatives markets bucket shops? Institutions and employees who deal with them will say that they are doing good work but if you were a neutral observer, what is your view? Are they creating wealth for society? Or are they simply gambling meccas misallocating the precious capital of the country?

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10 Response to Opinion: Time to start curbing the growth of derivatives

April 22, 2010 at 1:47 AM

Hi Sivaram,

Man, you have been busy over here.  Good work.  I also liked the piece on the Chinese real estate bubble.  As for derivatives, I'm kind of with Charlie on this one.  We're moving to more of a casino economy.  A great big game of chicken.  Except I get the feeling that both the house and the players may lose at the same time.   Personally, I'd rather we just got on with whatever lies on the other side, but while we wait, I will continue to enjoy your blog.

Geoff Castle 

Sivaram Velauthapillai
April 23, 2010 at 11:04 AM

Thanks for the compliment... although my blogging has slowed down of late...

I haven't checked your site and noticed that you have some good posts. I don't follow the Canadian real estate market much but I'm not sure if the situation is as bad as your are suggesting. I do think real estate is frothy but economic growth is fairly good (although I have to admit that income isn't flowing to workers so affordability is actually getting worse.)

Sivaram Velauthapillai
April 23, 2010 at 11:06 AM

Regarding your comment about derivatives...

Ignoring default risks and various other social costs, since derivatives are a zero-sum game, I think someone will "win." Someone is on the opposite side of the trade so they will gain in some manner.

P. W. Dunn
April 24, 2010 at 9:24 AM

Hi Siv:  This is an interesting post.  Obviously some of the derivatives of which you speak got out of hand.  I personally don't however see that regulation, by the US government is going to solve the problems, because they were so complicit in the creation of the bad product in the first place--the underlying sub-prime mortgages which backed the CDOs were created because of the Community Reinvestment Act.  Thus, how is the government going to clean up the problem through regulation without first dealing with the crap that they themselves are making?

I have a few  comments:

(1) Derivatives as a zero-sum game:  I think this is not correct.  While derivatives trading is a daily repositioning of ownership, the actual mark-to-market value of derivatives in aggregate changes from day to day based on fear and greed, and the underlying values which the derivatives represent are never static but grow or shrink depending on wealth creation or destruction.  Therefore the trade in this pie is never a zero-sum game.  At the essence of the market and thus of the derivatives trade, is enticing investors to risk their capital on the wealth creation of companies.  By submitting my savings to the market, whether in the form of a stock option, a savings account, or a CDO, I am allowing my capital to contribute to the economy as a whole.  This is at essence not a zero sum game, even if I only put $100 in a savings account, or speculate by buying a call for the same amount.  I am risking capital which will be used by the "market" to grow the economy.

(2) I am surprised to see your sort of blanket condemnation of all derivatives, lumping CDO's and stock options into the same boat.  I'm not sure that it is a good thing to lump all such products together in this manner.  CDO's bundled together bad mortgages with good and caused a collapse of the global economy.  I'm not sure that stock options can be said to have created the same problems; I've never even heard that they contributed to the recent collapse.

P. W. Dunn
April 24, 2010 at 9:24 AM

(3) I've recently begun selling puts and calls.  For me this trade can be explained as follows: 

Puts:  The seller accepts the risk of the stock going down for premium from the buyer.  The buyer pays a premium to insure against heavy losses.

Calls:  The seller limits his upside potential in a stock in exchange for a premium; the seller however accepts all the downside risk.  The buyer risks only the premium and the fees in order to win in case the stock experiences heavy gains.

Thus, stock options provide a valuable service both to the seller and to the buyer.  The buyer gets to participate in the market with less risk. The seller accepts the risk and for that receives a premium.  The broker receives fees.  Everyone wins.  It is not a zero-sum game.

(4) I do care about the long term values of the companies that I'm trading.  That is why I maintain long positions in most of them.  I am selling options because it allows me to realize an immediate gain of about 4-8%.  The risk of the covered call, admittedly, is that I trade the long-term upside potential for an immediate premium of 5%--but I am only selling covered calls on a fraction of my positions.

(5) Buffet sold puts to the tune of billions.  Well, it may be only small percentage of the total wealth at his disposal, but it is not trivial by any standard.

April 24, 2010 at 2:17 PM

You are right in pointing out that not all derivatives are the same. Also, the vast majority of derivatives (in nominal $ exposure) are interest rate derivatives and not the widely talked about options, futures, or CDS. However, I maintain my view that derivatives are a zero-sum game (assuming no defaults i.e. loser pays what he/she promised.)

PW DUNN: " This is at essence not a zero sum game, even if I only put $100 in a savings account, or speculate by buying a call for the same amount.  I am risking capital which will be used by the "market" to grow the economy."

If you put $100 in a savings account you contribute to the economy but that isn't necessarily the case if you buy $100 worth of options. You have no direct economic interest in the underlying asset. Sure, you are expecting or hoping that the underlying asset goes up (if you are long call options) but the reality is that you are getting closer to gambling than anything. These derivatives in an extreme sense are what the bucket shops in the 1920's--where you bet on stocks in some den without anyone dealing in the actual stocks--were engaged in.

There is a reason the US govt banned bucket shops and I think there is nothing to stop them from doing that again. You are skeptical that government will do such a thing but it happened in the 1930's. Right now it would be difficult because banks make so much money off derivatives--some even appear to have greater exposure to derivatives than to traditional lending to businesses/individuals--but I can see it happening.

Derivatives are helpful--commodity producers gain a big benefit being able to hedge for example--but the question is whether a huge chunk of the economy should be engaged in that business.

Options are a zero

April 24, 2010 at 2:35 PM

Zero-sum Game

Derivatives are a zero-sum game (if we ignore default risk and assume contractual obligations are paid out.) In contrast, investing in stocks, real estate, etc, can actually create wealth. The net wealth represented by stocks grows over time if the economy grows and corporate profits rise, but the net wealth represented by derivatives never ever rises--it is always zero. There may be some intangible benefits (such as allowing commodity producers to hedge production and manage risk better) but the actuall dollar amount never increases.

Derivatives are a zero sum game because every dollar you gain from, say buying a call option on Microsoft shares, will result in a dollar loss for the call option writer. If you plot the chart of your potential return at various prices, it will be exactly the opposite of the return curve for the seller of the option. If you lose $100 on a derivative, the person writing hte option gains $100.

In fact, it is entirely possible for the $100 you "spent" on a derivative to never flow into the economy or the company/asset underlying the derivative. In practice, option writers may hedge their position by entering the stock market or commodity market or whatever, but if we just look at the options market itself, the net outcome is always zero (there is actually some transaction cost/commissions/etc that is lost.)

In an extreme sense, all that is happening is that you, as the option buyer, and your opponent, as the option writer, are placing side-bets on some company/commodity/interest rate/whatever. This is why Charlie Munger equates it to a bucket shop. In the 1920's, people were betting their savings on the outcome of the stock market without purchasing a share or a bond. The fact that the shops taking the bets were dubious enterprises didn't help matters but even if they were clean, it wasn't really contributing to the economy.

I think the key element is the fact that derivatives are bets placed between side parties that may have nothing to do with ther underlying enterprise/asset. Your capital that flows into options may influence the underlying companies (when derivatives users try to hedge by actually purchasing or selling short shares) but it doesn't have to. You and I could enter into a contract to pay out some amount based on the price performance of Coca Cola but the money we exchange won't flow into (or influence) the company. Related to this, every dollar you gain is a dollar loss for me; and vice versa.

April 24, 2010 at 2:42 PM

One final point...

By the way, I'm not criticizing your strategy or saying you shouldn't do it. I think you are hedging your portfolio or at least trying to enhance returns a bit. I have also considered buying/selling options and don't think there is anything wrong with it.

I also don't think the government should necessarily ban them--I don't even know that's even possible.

However, the problem is when a huge chunk of the economy and the capital allocation of the economy (as Keynes suggested) relies on all these derivative side bets. To make matters worse, the key participants are the banks who are supposed to be the key lending institutions in the economy. I would be ok if the commercial banks did not engage so much in this activity and left it up to the investment banks and various other specialist banks.

For instance, JP Morgan is the key commercial bank in America, whom many businesses and consumers depend on, but if it collapses, it will be because of its trillion-dollar derivatives exposure and likely not due to its commercial lending. If that happens, what is going to happen to the "normal" lending--the stuff that actually helps the economy?

P. W. Dunn
April 28, 2010 at 4:34 PM

Thanks for these responses.  You make some valid points and I appreciate that you're not judging my current trading practices.  Time will judge that (I am new enought to this that I'm not sure I'll be successful with it).

I must concede that some derivatives today are undoubtedly only side bets comparable to bucket shops; at least that is what some are claiming about the derivatives from which John Paulson made a fortune.  I won't contest that point.  But I don't think that the argument really applies to stock options.  With covered calls, I must own the stock. With uncovered writing, I must always have sufficient margin to pay for the stock at the strike price in the case of a put or to supply the stock at the current market price in the case of the call.  So I am not sure why you consider stock options a side bet without relation to underlying securities.

Now also consider that in the case of a bull market, the covered call results in the seller receiving the price he wants for the stock plus a premium.  The buyer receives an option on an asset which has appreciated, and in the case of exercise, the buyer has the possibility of making a large amount of money without little risk.  Both actually win in this case.  In the case of the bear market, the seller of a put receives a coveted asset at a desired price, plus a premium.  The buyer of the put is able to offload a stock before it becomes a drain to his portfolio; again both win.  It is true that there can be losers--apparently the majority of options contracts expire worthless--in which case the premium is lost to the buyer of the option--but it is still a service that he has bought too that even it doesn't win, he is able to play the market with peace of mind. 
Also the naked call (a very risky form of option writing) can result in losers even in a bull market.  But in an ideal world, the bull market, everyone, both the buyer and the seller, wins while the economy expands.  This is not a zero sum game.  From what I can see, therefore, the options market is just a different way to trade the actual stocks--and most people accept that the stock market itself is not a zero sum game because it is based on actual companies which are able to grow the size of the pie.

P. W. Dunn
April 28, 2010 at 4:36 PM

That should have read "with little risk" not "without little risk".  Cheers.

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