Don’t Stifle the Prudent!

Story Highlights

• The summer's credit fears are morphing into calls for regulation and better disclosure from financial institutions and the widely misunderstood derivatives market is taking undue blame
• Derivatives are a beneficial capital markets tool aiding financial stability, not exacerbating volatility or risk

We applaud what's turned out to be a very shrewd move by the big US banks in forming their own bailout fund should a new credit crisis emerge. Don't get us wrong, the fund in itself is a bit silly. The notion a $100 billion dollar nest egg (relative to bank assets worth trillions) would truly help in a major credit crisis is laughable. But the upshot is banks have effectively taken the venom out of Congress's ability to "fix" the credit problem with new regulation.

Bailout Kings
By Paul Tharp and Roddy Boyd, The New York Post

But the regulatory dangers aren't averted quite yet. In the wake of the fake credit crisis (see our past commentary, "Ben to the Fake Rescue!" 9/19/07) for more), folks are getting nervous about derivatives and there's even talk of regulating them.

Derivatives are difficult to understand and are in many respects opaque to market participants. Forward contracts, options, swaps, and so on, are admittedly complex and few truly grasp their scope or inner workings.

The unknown creates fear, and that's probably why headlines filled with "coulds" and "mights" are so effective. Pointing out something bad might happen isn't expressly misleading, but it goes a long way in selling fear, which in turn sells newspapers. (See yesterday's commentary, "Same Old Song and Dance" for more.) The below story issues a dire warning on derivatives markets: "Blind spots, bottlenecks lurk among new ways of preventing a crash." Scary!

The More Hedges the Better, Right?
By Gregory Zuckerman, The Wall Street Journal

We don't mean to pick on this particular story—the belief derivatives are highly risky to stable markets is common. But sophistication doesn't necessarily mean dangerous. We've argued derivatives are not only a fine thing for markets, but they create greater stability, not less. (See our past commentary, "Deriving Stable Markets" 11/06/06, for more.)

Insurance products are a great way to think about this issue. People generally accept that insurance is a good way to mitigate risk. We use insurance to hedge against catastrophic risks like the loss of life, autos, and housing. Insurance is effective because it pools money together amongst a vast group of people to lower the cost of protecting against specific events occurring to specific individuals.

We don't typically hear folks screaming, "There's too much insurance out there! All this risk is spread throughout the economy…it'll eventually bring us down in a ball of flames!"

The function of derivatives in today's global market is similar. Don't get us wrong: We're not saying derivatives are insurance. But we are saying derivatives can be thought of as risk mitigators in a related way. The vast majority of derivatives are used by large financial institutions to mitigate exposed risks, not exacerbate risk or speculation.

Let's say XYZ bank, based in France, has a portfolio of assets to the tune of $100 billion, denominated mostly in US dollars. The bank's officials recognize they are highly exposed to the dollar, so they purchase $500 million worth of derivatives benefiting from a rise of non-dollar currencies. This helps hedge (or protect) bank assets against a meaningful drop in the dollar's value.

Many would say "Yikes! $500 million in derivatives, that's crazy! Derivatives are far too speculative and risky for a plain vanilla bank." But in reality the bank has merely dedicated a small portion of its assets into a contract stabilizing portfolio value against risk.

The vast majority of the derivatives market is conducted on this basis, with billions of dollars changing hands daily as financial institutions across the world hedge their risk exposure. Sadly, most folks only hear about those who use derivatives for "naked" or completely speculative investing adventures. But those are in the acute minority.

Additionally, and very importantly, derivatives are a zero-sum game. Differing from true securities, derivatives are a contract between two parties in which one side wins and the other side loses. If, for example, XYZ bank loses its $500 million derivative bet against the dollar, then whoever took the other side of that bet wins the $500 million. But no matter what, wealth only changes hands and is not destroyed.

Lastly, the summer's stock market correction is probably ample evidence the derivatives market is stable. In the midst of a truly dire credit crisis where lending activity halts, one could reasonably expect derivative markets to do the same. Yet, throughout the turbulent market correction and hiccup in credit activity, derivatives activity kept right on chugging.

We sincerely hope regulators see new financial instruments correctly and do the right thing by allowing capital markets to develop of their own accord. The benefits to society in building increasingly stable capital markets using derivatives are too large to do without, and there's little gain in punishing those with the prudence to mitigate their risk to begin with.