Asset and wealth management – Regulation, free markets and derivatives

Asset and wealth management – In the Washington Post of Saturday, July 11, 2009, in an article headed “Geither Pushes Derivatives Plan” a staff writer, Zachary A. Goldfarb, says that “trading in derivatives — which are essentially contracts between two investors betting on whether a stock, bond or other security will go up or down in value – has mushroomed into the world’s largest market, estimated to be in the tens of trillions of dollars.”

Asset and wealth management - Regulation, free markets and derivatives

This statement tends to create the impression that derivatives are essentially gambling instruments for ‘investors’ and probably belong more in casinos than in financial institutions. Nothing could be further from the truth.

The Nature of Derivatives

According to asset and wealth management, derivatives instruments have been used for risk management in agriculture for millennia. Forward contracts and options to buy and sell were known to the ancient Greeks and recognized by Roman law.

Modern innovations are trading derivatives on public exchanges, the adoption of novel underlying assets such as indices and the weather, and the creation of involved, convoluted aggregations that defy proper pricing. Understanding the nature and usefulness of these instruments is essential for assessing the desirability of regulating them in a free market, capitalist system.

Derivatives derive their money value from something else. The ‘something else’ must be an asset that has a value sounding in money, such as fixed property, a defined weight in gold bullion or a standardized quantity and quality of wheat. Such assets are called the derivative’s ‘underliers’. Any class of asset can potentially form the underlier of a derivative, except for those trading on public exchanges, where very strict rules apply.

Forward contracts, an ancient derivative, allow asset owners to sell such assets forward, i.e. for future delivery, at today’s price. This protects them against market fluctuations over a particular period. Traders who plan to purchase assets in the future want to protect themselves against price rises. They thus buy assets forward, acting as counter parties to the forward sellers.

All derivatives, however named, essentially contract into the future.

Asset and wealth management

The above are examples of hedging. In a 2002 book “Managing Interest Rate Risk,” published in London by John Wiley and Son, John J Stephens says that essentially “hedging is taken when one risk is intentionally incurred in order to offset or neutralize another risk.” Hedging makes uncertain outcomes certain; it can only be done using derivative instruments. Derivatives are thus risk asset and wealth management instruments for traders, not casino games for ‘investors’.

Although they are essentially risk dampers, derivatives can obviously also be used for risk taking. Speculators, who have no real interest in the underlying assets, use derivatives to place bets on the underliers’ price movement. This is not peculiar to derivatives; all risky assets, from fixed property to stocks, bonds and livestock are subject to speculative trading.

Two Modes of Derivatives Trading – Exchange and OTC

To evaluate the role of derivatives and regulation in the current economic meltdown, the two trading platforms can be compared.

Derivatives, such as futures and options are traded on public exchanges such as the CME and the LIFFE. Trading is strictly regulated. The underliers are exhaustively defined, the terms of the contracts minutely stipulated while the integrity of the exchange safeguards the process. The exchange clearing house requires margin deposits for a trade and regularly calls for more when prices move adversely. Every transaction is guaranteed for all parties.

OTC is an acronym for ‘over the counter’. OTC derivatives have no independent guarantee of the quantity, quality or value of the underlier. Only the integrity of the seller underwrites the transaction. Because the underlier itself is not traded, the value is opaque and subject to manipulation. The complexities of OTCs have grown exponentially with underliers bundled so convolutedly that they defy pricing.

Asset and wealth management

The economic meltdown was not caused by exchange traded derivatives. It was caused by traders packaging virtually valueless underliers into complex derivatives, the instrument’s opacity hiding the lack of value. Buyers in good faith were misled by the reputation of the sellers, who were raking in billions on valueless assets. The sellers, gambling on a nonstop rise in prices, figured they were safe because, even currently valueless underliers would eventually realize the nominal values of the trade.

The comparison makes a stark statement: right regulation is the difference between success and financial ruin. The case for independent regulation is unanswerable.

Regulation, Free Markets and the Liberal Agenda

The Washington Post article reports US Congress Republicans expressing “concern that the administration’s plan could stunt financial innovation and end up costing U.S. businesses more.”

Deceitful, misleading conduct isn’t ‘financial innovation’. Regulation is not in principle anathema to the free market or economic efficiency. Human society requires rules and laws. Institutions matter. Public exchanges demonstrate: right regulation make markets work. Absent regulations, markets fail.

Unregulated markets aren’t free; they are dangerous. Where the strong prey on the weak, where the unscrupulous lie in wait, economic activity ceases. The integrity of the ‘rules of the game’ lies at the base of a free, fair market.

In an article headed “The Liberal Dilemma,” published on on 12 July 2009, Michael Ignatieff, leader of the Liberal Party of Canada, writes that “Protection of the public interest requires regulation … Governments will need to regulate markets but will have to find a way to do so without stifling market innovation.”

Modern financial markets are unthinkable without derivatives. OTC derivatives must be regulated to become transparent, fair and secure. It’s Government’s job to eliminate systemic risk from the market place; then to allow market makers to get on with the job.