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April 22, 2010

The Truth About Derivatives

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Demanding Diversity Through Uniformity“Derivatives” have gone from being the hottest thing on Wall Street to being the hottest thing in Washington. Indeed, President Obama -- who mentioned them no fewer than three times during Thursday’s Cooper Union speech -- has vowed to veto any financial reform bill that doesn’t attempt to regulate them.

On April 14, President Obama hosted congressional leaders for a showy “summit” on financial services reform. He called for “a strong mechanism to regulate derivatives,” among other goals. On Wednesday the Senate Agriculture Committee approved legislation introduced by Chairman Blanche Lincoln that would require sweeping changes in derivatives markets, far beyond even what Obama and Senate Banking Chairman Christopher Dodd Propose.

Obama, Lincoln and Dodd want to regulate the derivatives trade (which, he said Thursday, operates “in the shadows of our economy”) because, they say, derivatives caused the 2008 financial crisis. But is the premise -- that derivatives caused the crisis -- true? And does the charge apply to everything called a derivative?

In the financial world, investments with bigger risks also offer potentially greater returns. You’re more likely to become a millionaire by investing in an Internet start up than by leaving your cash in a passbook savings account. You’re also more likely to lose your entire investment.

So many risk takers turn to derivatives to transfer some of their risk to someone else. The second party is paid a fee to assume the risk. Risks transferred may be related to prices (whether they rise, fall or fluctuate), interest rates, exchange rates, or whether a third party will pay its debts. Derivatives play a productive economic role by allowing firms to plan based on stable economic factors while transferring some risk (and some potential rewards) of economic disruptions to others willing and able to assume it.

The key point is that derivatives do not create risk; they transfer it. Of course, companies that foolishly assume too much risk, as insurance giant AIG did with some derivatives, can suffer huge losses as a result. But those losses did not cause the financial crisis; they were a result of the mortgage market meltdown. Indeed, derivatives are economically valuable precisely because they are where the losses show up.

This isn’t the first time derivatives have been wrongly blamed for causing a stock market crash.

In the wake of the 1987 crash, then-New York Stock Exchange Chairman Richard Phelan blamed a new and fast-growing derivative -- S&P 500 Index Futures -- for the problems at his exchange. Phelan’s charge sparked an outcry for more regulation. But after the crisis subsided, careful studies concluded the 1987 crash wasn’t caused by derivatives but by macro-economic factors and government policy mistakes, including anti-takeover legislation. To the extent that flaws in markets intensified the crash, the problems were in the NYSE’s own antiquated order-fulfillment system.

In the wake of Lehman Brothers’ 2008 bankruptcy, former CEO Dick Fuld blamed a new and fast-growing derivative -- credit default swaps -- for his firm’s failure. But a year later, Lehman’s bankruptcy examiner found Lehman failed due to its own poor business decisions. Lehman’s derivatives positions represented only about 3.3 percent of its net assets and the examiner found its derivatives trades were reasonable and more carefully monitored than other asset classes.

Obama and Lincoln want to try to reduce the risk of another market crash by making derivatives more expensive and more difficult to use. There are serious arguments about the role of derivatives in concentrating and communicating risks across markets. But as Phelan and Fuld’s inaccurate accusations show, initial claims can be misleading.

The Obama-Lincoln solution is to just regulate everything. But regulating everything would mean regulating the wrong things, and in the wrong way.

Some derivatives, such as commodity or stock futures, are already federally regulated. Other derivatives related to financial transactions such as interest rates, foreign exchange and debt are traded largely over-the-counter among banks, whose operations are regulated by the Federal Reserve and other banking agencies.

There’s no suggestion that interest rate swaps (the largest category of OTC financial derivatives) or foreign exchange swaps played any role in the financial disruptions of 2008. Yet the Obama and Lincoln proposals extend regulatory rules for physical commodities and stocks to these bank-based products.

Wantonly extending commodity-focused regulation to financial derivatives applies the wrong tool in the wrong application. Like using a hammer to drive a screw, the result would be ineffective regulation, damaging everything involved.

The Obama-Lincoln proposals amount to little more than a frenzied insistence to do something -- anything -- to regulate financial derivatives. Yet applying ill-designed regulation would make financial derivatives more costly, more difficult to customize and consequently less widely used. Because properly used derivatives reduce rather than increase financial risks, bad regulation would increase overall risk in the economy.

Rather than regulating everything with a one-size mandate, Congress should address specific problems in derivatives markets. Lawmakers should encourage the risk-mitigating uses of financial derivatives. For investors, bad regulation is worse than none at all.

David M. Mason is a Senior Visiting Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

First appeared in FOXNews.com

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