Derivatives should not be banned

The internet has been commonplace since the mid 90s and has been instrumental in all sorts of atrocities. Would I ban it? No way. The benefits far outweigh the costs.

That's not the approach that Alan Kohler took in his Business Spectator column Derivatives should just be banned (22 August).

Unlike the internet, derivatives have been around for a while. Futures trading on Japan's Dojima Rice Exchange began in 1710. The first commodities forward contract was written in the United States in 1851 and even the relative newcomer – the financial derivative – has been traded since the early 70s.

Before banning a centuries old activity outright, just imagine how the world would look without them.

If you have a mortgage, prepare to start winding back your living standards. Interest rates are about to go through the roof.

Without derivatives, our banks would be forced to fund themselves in Aussie dollars. Borrowing more cheaply in US dollars or euros – swapped into local currency using cross currency swaps (a derivative) – would be a thing of the past.

As banks would be unable to write interest rate swaps to hedge themselves against rate changes, fixed rates would end and borrowers would be forced onto higher, more volatile variable rates than the rates we know today.

If that's bad for the borrower, it's even worse for the banks themselves.

Reliant on large volumes of foreign debt, banks probably couldn't fund themselves in Aussie dollars. Their choice, in Alan's world, might be to fund in foreign currency and pray that exchange rates don't move against them – in which case, kaboom – or to substantially rein in lending (which, admittedly, might be a good thing).

If you're highly leveraged, expect a call from your bank manager.

As for exporters and investors in foreign assets, exporters would have to find a customer willing to buy their product at a fixed price several years hence. That would create massive credit risk.

Both exporters and investors, being unable to hedge against currency volatility, would simply have to live with it, or find another counterparty, adding another layer of credit risk. Exporters would sensibly focus only on those products with the highest profit margins, cutting back on the high volume, lower margin lines. That would mean fewer jobs and less tax revenue.

The only way for most investors to mitigate currency risk would be to sell their investments.

Even the much maligned credit default swap would be missed. Yes, really. This market allows banks to lend to a company knowing it can easily reduce their exposure if need be. It's good for borrowers as it increases the potential demand for debt.

Our banking system borrows hundreds of billions of dollars from the global capital markets. So do Australian governments. As one of the world's biggest users of the sovereign credit card, we should be hailing the benefits of the CDS market, not arguing against it.

But the biggest problem with Alan's argument is that it detracts from the real issue.

The concern should not be the existence of derivatives per se. Instead, we should focus on the extent to which they've infiltrated the banking system and some of the uses to which they are put.

Organisations should have the right to blow themselves up on derivatives. What they don't deserve is taxpayer largesse when they do.

Calls to limit the proprietary trading of taxpayer-backed banks are fair and reasonable, especially when banks have shown a remarkable inability to manage trading risks. Think NAB's Homeside and foreign currency disasters.

But we don't have to ban derivatives trading altogether to prevent its downsides. Regulators like APRA can tackle it through the capital adequacy rules, which aim to keep banks and taxpayers safe by telling banks how much capital they must hold.

Right now, capital is held against derivatives risk based on finely tuned mathematical models and ‘ideal world' assumptions. ‘Netting' is a good example. Bank capital rules allow positions to be ‘netted', meaning billions of dollars of liabilities between institutions are reduced to a single, much smaller, exposure.
Some banks might cease to exist if netting didn't work exactly as has been assumed.

If APRA (and other banking regulators) insisted on a tougher policy for allocating capital to trading positions, banks with moderate derivatives books could absorb it within the capital ‘buffer' they usually hold. There would be no need to fear a rush of bank share issues.

Banks that ended up short on capital, due to a large or poorly performing derivatives book, would need to either raise more capital or reduce the size of their proprietary trading business.

That's a small regulatory change with a very useful and substantial impact. Only the traders would suffer, and we shouldn't worry too much about them.

Alan's right in one sense, though.

Plenty of derivative trading serves no useful purpose. There's a case to ban, for example, derivatives dressed up as high yield securities sold to retail investors, which do nothing to help exporters or fund mortgages.

The finance industry has bigger problems than those created by derivatives trading, for which there is a simple fix.

Rather than call for an end to a practice started by the Japanese rice traders in 1710, let's address the conflicts of interest in financial advice, which FOFA won't fix; high frequency front-running, the systemic risk posed by funding residential mortgages with foreign debt and a financial culture that says ‘if you can get away with it, you should'.

Derivatives can wait.

Richard Livingston is Managing Director of Intelligent Investor's Walnut Report.