Derivatives should just be banned

Most derivatives trading involves creating risk from thin air and gambling on it. And one New York fund manager warns the structure, now worse than in 2008, will collapse again if something isn't done.

Almost all financial derivatives trading adds nothing but risk to the world and should be banned. It won’t be, but that doesn’t mean the debate is academic.

Regulators are attempting to bring derivatives into the light through mandatory exchange execution and clearing and "Legal Entity Identification” rules, but progress is slow and fragile. It can be filed under "B” for believe it when we see it.

But is there any reason to allow financial derivatives at all? In my interview with him this morning, New York hedge fund manager James Rickards says they should simply be banned because the benefits are illusory and the effect is that risk is created out of thin air and then multiplied.

That’s what happened in 2008 and, says Rickards, the problem is worse now: "The derivatives books are larger. If we had a problem then, we have a bigger problem now. This will collapse again if we don’t do something about it.”

Most derivatives trading involves swaps or contracts for difference, where two people bet on movements in an underlying asset or income flow without actually trading in it. It’s a bit like betting on flies crawling up a wall, without having to buy the flies.

What’s more, they are usually traded "over the counter”, which means the deal is just put through by a broker and doesn’t go through an exchange – what ASX CEO Elmer Funke Kupper would call "dark execution” as opposed to "lit”.

Credit default swaps are bets on whether a country or company will go broke, interest rates swaps are bets on movements in interest rates, contracts for difference are bets on movements in a share price or other asset, and so on. Futures contracts and options are derivatives as well, and there are a variety of derivatives based on home mortgages, although these have fallen into disuse after the GFC.

In fact, derivatives caused the 2008 global financial crisis because banks and investment banks vastly multiplied the leverage on their balance sheets by betting through derivatives and then losing control. Since then the amount of derivatives outstanding has actually grown, and now stands at more than $700 trillion.

At the Cannes Summit last November the G20 issued a communiqu that all "All standardised over-the-counter derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and centrally cleared, by the end of 2012.”

There is little chance of that happening, and even if it did there were enough qualifiers to drive a CDS truck through. Nevertheless, regulators are grinding their way through consultation and report production with a view to eventually dragging OTC derivatives trading into the open, where the players at least have to say who they are.

The US Dodd-Frank legislation, passed in 2010, requires non-US banks to register as swap dealers with US regulators from next year if they want to trade derivatives there.

Guess what? Reuters reported last week that Asian banks are cutting their relationships with US banks so they don’t have to register, and US banks themselves are restructuring so they can keep going.

Let’s be clear: basically we’re talking about a casino where the gamblers are banks. And banks aren’t just any old punters: they also take deposits and lend money, underpinning the financial system on which society rests.

As with all casinos, someone always loses their shirt occasionally – LTCM in 1998 (US$4.6 billion), UBS in 2011 ($2 billion), AIG 2008 ($18 billion), Barings in 1995 ($1.2 billion), Societe Generale in 2008 (7.2 billion), and so on.

The losses of shirts don’t always cause a general financial crisis, but there’s always a wobble and in 2008 the combination of AIG, Merrill Lynch and Lehman Brothers and a few others did cause a global recession and is still causing widespread misery.

James Rickards says most of the arguments put forward in favour of financial derivatives are spurious.

The proportion of derivatives trading that involves a genuine business person – a farmer or a commodity buyer for example – offloading their risk, is tiny. Most involves the creation of risk from thin air and gambling on it.

It’s often argued that derivatives trading allows more accurate price discovery, especially in the credit default swaps market. Actually there has always been accurate price discovery in the bond market.

But the main problem is that banks have shown time and time again that they can’t control it. Either there’s a rogue trader who loses billions or, as with sub-prime mortgage derivatives, the whole system gets out of control over time and then blows up.

If derivatives can’t be banned, then perhaps banks should just be stopped from trading them and putting their capital at risk. Oh wait a minute, they used to be – it was called Glass-Steagall, but that was repealed.

Follow @AlanKohler on Twitter

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