Criticisms of Derivatives

When some people look at the size of the notional value of the derivatives market, the actual value of the underlying assets or contracts involved, the numbers can look pretty scary to those who don’t really understand what they mean.

No one is even that sure of how big this market is but it’s well over half a quadrillion dollars and some believe it’s closer to a quadrillion. A quadrillion dollars is a lot of money, and the numbers that are thrown around in the derivatives market add up to 10 times or more of the world’s GDP.

We’re talking an amount of money that is at least 30 times bigger than the entire market capitalization of all the world’s stock markets combined, so that’s a lot of money indeed.

A lot of this notional amount involved in derivatives isn’t exposed to market risk though, and what is exposed to it generally would be exposed to it anyway. For instance, over half of this number is from interest rate swaps, and it’s just the interest rates that they are swapping, not the principal amounts.

These principal amounts are of course exposed to their own risks, default risk for instance, but this has nothing to do with the risks involved in the interest rate swaps that the derivatives market facilitates.

So there’s nowhere near as much money at risk than it appears, not the 800 trillion that may be associated with it, but nonetheless the derivatives market does expose a lot of money anyway, and the number is still pretty big compared to other markets.

There is a lot of government issued debt out there and this is the biggest reason why the derivatives market is as fat as it is, and these debt instruments are hedged. This hedging reduces the overall risk, or at least transfers it to those who are better equipped to manage it, where the underlying risk doesn’t change but it’s impact will typically be reduced this way.

Derivatives Are Really About More Efficient Allocation of Risk

Some of the notional value of derivatives is very much exposed to risk. Credit default swaps are a good example of this, and the exposure of these contracts can be great, just as an insurance company’s risk exposure can be great during events that require massive insurance payouts.

Insurance companies hedge their risks through purchasing re-insurance, insurance for insurers, and the credit default market works similar to that, transferring the risk to parties who are better able to handle it and are willing to collect a fee to provide this protection.

When we see a lot of defaults though, it’s not the hedging that caused the defaults, any more than reinsurance causes disasters. The risk was there already, and what the swaps did was allow those holding the debt to insure themselves, which makes not being able to handle what happens less likely, not more so.

So when people like Warren Buffett and others claim that the derivatives market is like a ticking time bomb, we need to question this, as derivatives don’t create the bombs, they just make managing the explosions easier and more efficient.

We can view all derivatives markets the same way, as all look to reallocate risk for a fee. It doesn’t matter if we’re talking about futures contracts, or options, or interest rate swaps, or forex swaps, or equity swaps, or credit swaps. All of these involve the redistribution of risk.

No matter how intricate or “exotic” a derivative is, it is all about bringing two parties together to transfer cash flows and risk in the combination and to the degree that is desired.

The only real risk is default risk really, at least in terms of systemic risk, as everything else just involves a certain flow of capital from one entity to another. When people criticize the derivatives market they are criticizing what is supposed to be the adding of systemic risk, which is apart from some gaining and some losing, which is within the system and not a risk to it.

Aside from situations like people buying derivatives that they don’t properly understand or that the risks aren’t disclosed properly to, which are absolutely required if derivatives are to function properly, the existence of derivatives reduces rather than adds to systemic risk, the risk of obligations not being met and systemic losses happening as a result.

Derivatives and Individual Risk

Derivatives, by way of the way that they are traded, can certainly be more risky than other types of investments such as stocks and bonds. Derivatives are often more highly leveraged, due mostly to more relaxed regulations surrounding them, and where one may need to put up half the money or more with buying other assets, traders can get by with just putting up a few percentage points of the value of a derivatives contract.

While regulation in financial markets do have their rightful place, to make sure that the required information is disclosed, to make reasonably sure that a broker or investment bank can meet its financial obligations to their clients, to prevent abuses of the system, and so on, one still needs to be left to make one’s own decisions about how much risk one is willing to take on.

If someone wants to put their retirement money up and buy as many contracts as they can of an option that is way out of the money and is very unlikely to hit the strike price, as unwise as this would seem, it is still their prerogative as it is their money.

If someone who was a trustee of a fund did that, we would want to prevent that, and that would be the absolute right thing to do unless those whose money he was managing had full knowledge and were in complete agreement with this strategy.

So people bust their accounts trading derivatives all the time, as well as busting out trading other things, although it certainly is a lot easier to do this with derivatives due to the much higher leverage available.

So the fact that people can make bigger bets essentially with their own money should not trouble people at all, because it is their money, and they could also blow it at a casino as well if they wanted.

Therefore, the fact that many traders lose money trading derivatives isn’t a problem with the derivatives itself that’s for sure, and while people can claim that people need to spend their money according to the way these critics believe they should spend it, that’s not even a valid criticism at all, and is akin to saying that people should not spend their money on gambling and such.

Some Legitimate Concerns with Derivatives

The real concerns with derivatives, the ones that have some sort of validity, have to do with things like the risks with them not being disclosed enough, or their being used inappropriately to increase one’s exposure beyond what they have a duty of care to avoid.

Provided one understands the risks involved, there is no issues with derivative trading or accumulating derivative contracts, but this is not always the case. In some cases, like with individuals, it may be from not doing their due diligence or from making poor decisions.

In other cases, like with large institutions exposing themselves to way too much risk, we may also see poor decision making, like the trader who bankrupted Barings Bank with a derivative position by making unauthorized trades. Things went very poorly with these trades, and he just added to the position to look to recover, but the recovery did not happen. The bank could not cover the $1.3 billion this trading lost for them and after being in business for over 200 years, their history came to an abrupt end.

When a financial institution is over leveraged to the point where a normalization of home prices would cause their collapse, and they let such things happen, and the government has to bail them out, this is a perfect example of why we need regulation.

Governments are usually eager to regulate and often will over regulate markets, especially when institutions are at risk. The fact that regular mutual funds cannot take short positions is actually quite ridiculous for instance, and this is merely a result of a bias toward the long side of markets that doesn’t even make much sense.

The derivatives industry still exists in a fairly opaque environment though, mostly due to the lack of oversight that you tend to see in over the counter markets, and we’re talking over the counter markets that legislators tend to lack a proper understanding of.

We certainly can benefit from more structure in many types of derivative contracts though, where what is actually going on is more in plain view. In particular, we have learned that leaving institutions to their own resources, where short term gains take such precedence over risk exposure, doesn’t always provide sufficient protection.

It always comes down to making things transparent enough, and transparency is one of the major goals of financial markets. When the shareholders don’t really know what’s going on, then you can have some real trouble, but if they end up being aware enough of the sort of risks their company is taking, this can temper their desire for the price to go up, at least with the long term shareholders.

With individuals, the fact that we might tell people that trading in derivatives involves higher risk doesn’t always hit home properly either. There are people who do very well trading derivatives, but for every successful derivatives trader, there are 10 or more that lose money in these markets consistently.

The time to become aware of the challenges here isn’t after you have busted out your account, and even that isn’t sufficient in a lot of cases. This is an example of how we need to make things more transparent, and having brokerages for instance disclose trading stats of their clients would be an idea that would at least shed more light on what traders are up against, rather than the lip service they give it now.

Derivatives are in themselves a wonderful tool which, when used properly, allow people to not only hedge risk, but to provide more liquidity to markets and even make a profit speculating on them if they are good enough.

The blame or risk should never be placed on the derivatives themselves, but we do have some very good reasons to do our best to ensure that these securities are made as transparent as we can make them, because that’s an essential component of market efficiency.