When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done.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.
— John Maynard Keynes
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? Tags: Charlie Munger, econopolitics, opinion