Derivatives: Educate, don't legislate

It's hard to know what Alan Kohler's dislikes most about the finance world. I thought it was high frequency trading, but his most recent article Throw the Gaming Act at derivatives bookies suggests that derivatives are fast catching up.

Alan's basic argument is that derivatives have been used by a whole bunch of less scrupulous (or less knowledgable, depending on your view) finance types to convince unsophisticated investors to make bets they didn't understand. On this, I wholeheartedly agree. Where misleading sales techniques were used to dupe investors, the institutions and individuals involved should suffer the consequences. Similarly, negligent investment managers should be held to account.

But Alan then goes on to argue that derivatives are, in essence, gambling contracts that should be regulated (and effectively outlawed) by the Gaming Act. This is where Alan and I part ways on our thinking.

Firstly, let me acknowledge a bias. As a general rule, I believe that regulation is a poor way of influencing behaviour and I believe strongly in the 'law of unintended consequences'. I have seen far too many instances during my career of financial products, or entire industries, that only exist because of laws or regulations originally aimed at something else. The golden principle that policymakers should keep in mind is 'if you make a rule, you create a market for arbitraging that rule'.

Back to derivatives and their regulation as gaming contracts. To argue that this might have been a solution to the problems of Lehman/Grange and their dodgy CDOs ignores the role played by other factors, particularly that most basic of human behaviour—greed. Since the dawn of time (or the start of the finance industry at least) greedy, unscrupulous salespeople have been stitching up greedy, gullible investors, often with the help of somewhat disinterested third party advisors.

Would regulation of derivatives have made a difference in this case? Or would the Lehman spruikers simply have found another way to fill a special purpose company with garbage, game the ratings agency process and sell rated securities to investors desperate for the extra yield and not interested in spending the time to understand the underlying assets or their inherent risks?

I think the answer is 'yes, they probably would have'. Securitization started with real loans, gradually moved on to lower quality loans and, only in the later stages, did we see the widespread use of CDOs based on synthetic cash settled derivatives.  Synthetic CDOs may have been the easiest version to create and sell at the time but, given the mass of liquidity seeking extra yield, I suspect Lehman would have found a way to package up an alternative form of garbage.

At the time, Lehman and the ratings agencies were hungry for fees, investors desperately wanted yield and everyone had forgotten risk existed. In this environment something of dubious quality was always going to get sold.

The other problem I have with Alan's argument is that it picks on derivatives for regulating as gaming whilst ignoring the fact that all securities and financial contracts are essentially a 'bet'. For instance, buying a share is a bet that company will outperform alternative investments, a fixed rate term deposit is a bet that interest rates will fall and a call option is a bet the company's share price will rise before the option matures. Even an insurance contract is a bet that an event will or won't happen.

There is nothing about derivatives that makes them more or less of a bet than any other security or contract. Some derivatives are high risk, bordering on ridiculous, sure. But then so was margin lending into a fad stock like ABC Learning or Babcocks, or subsidizing the planting of the wrong trees in the wrong place with Government tax concessions. The world of finance is full of ridiculous bets and they don't all rely on cash settled derivatives.

Apart from disagreeing with the suggestion, the reason I don't like taking the argument down this path is that it draws attention away from the real problem. I have previously said that the big issue we have in our finance industry is a (very American) culture of 'if you can, you should'. No amount of regulation is going to make the Lehmans of this world ask themselves if selling overpriced, dud investments to unsophisticated investors is the right thing to be doing, or even just a sensible business strategy.

Change will only come about with a large injection of morality into our finance industry (unlikely) or with investors taking the time to educate themselves. The Government should be focused on facilitating that education, rather than working out what to regulate next.

First lesson for investors would be to never rely on reports, ratings, research or advice provided by the seller of a product or an independent expert being paid by them. Sure, this material can provide some more useful insights than a Product Disclosure Statement or Prospectus (and generally has the advantage of being, at least, decipherable). However, ultimately, unless investors are prepared to do the hard yards themselves, or engage a truly independent expert, they should stay clear.

We don't need the Gaming Act, we need more education. The first lesson alone would have been enough to save the funds of Wingecarribee Shire Council and its ratepayers.