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Derivatives Market: Is More Regulation Needed?

November 28, 2010 Leave a comment

“ … [They are devised by] madmen; [they are equivalent to] hell… easy to enter and almost impossible to exit… [they are nothing short of] financial weapons of mass destruction” (Anon, 2003a). These are the views of investment mogul, Warren Buffett, when it comes to derivatives. At that, one must stop and question: if derivatives are that bad, why do investors deal with them in the first place? Surely they must have some benefits! In that case, what if they were to be [more] regulated: would that negate their inherit risk factor? Prior to exploring the implications of further regulating derivatives, it would serve best to briefly talk a bit about derivative basics.

The Basics

The investment world is split into two camps; that of the traditional investment instruments [stocks, bonds, cash and properties] and the alternative investments instruments [everything else: stamps, commodities, etc]. Derivatives, which falls under the alternative investments scheme, “is a contract between two parties where the value of the contract is linked to the price of another financial instrument or a specified event or condition” (Min and Garofalo, 2010). There are many types of derivative contracts [ the more common ones are: swaps, futures, options, etc], each baring a unique set of terms and conditions. But essentially, all derivatives fall into one of two groups:

> Over The Counter (OTC) derivatives: these contracts are not traded in any exchange. They are privately executed contracts, where usually one of the involved parties is a bank or a hedge fund. Such derivatives are highly flexible, but “suffer  from  greater  counterparty  and operational risks, as well as less transparency”(Acharya et al., 2008)

> Exchange Traded Derivatives (ETD): “The most centralized form” (Acharya et al., 2008) for trading derivatives; as they are traded through specialized exchanges.  The derivative contracts are standardized. Such exchanges bring along with it higher transparency; yet more inflexibility is introduced.

Let’s Dig Deeper

So what are the advantages of investing in derivatives? I shall hold the answer to this question, as the advantages [and disadvantages] will be inferred from the subsequent Pros/Cons sections. What I want to touch upon is the raging debate on whether derivatives should be subjected to more regulations. On one side of the argument, since derivatives essentially have no value of their own, the call for more regulation is a result of genuine concern. As our free-world economy is profit centric, greed may derail our economies at any given time. The hardly regulated derivatives market is one of such greed channels; as we were reminded so, by the most recent pinch from the 2008 mortgage crisis.

The outcry on the other side of the argument, is that regulation will dampen profits. Essentially, the push for more regulation is just a way to channel the profits to other players.

This regulation debate, is really a modern twist on old philosophical debates regarding freewill and self-mastery discussed by the likes of Plato, David Hume and Thomas Aquinas: are there any benefits to control and regulations? And if so, how much much is deemed beneficial?

Pros: More Regulations of Derivatives

There are a lot of positive attributes when it comes to more regulations of the derivatives markets, which include:

> Better Risk Management: Derivatives are used as hedging tools; thus “companies and banks [may hedge] against unexpected developments, for example sudden falls or rises in the value of currencies or commodities” (Anon, 2003b). With more regulation, more information will be available; facilitating better hedging and risk mitigation.

> Protecting the Economy From Collapsing: this also hinges on the more information argument; which effectively brings with it more efficient markets. The higher levels of transparency, allow for easier identification of “systematic risk” (Min and Garofalo, 2010) build ups. This aids in steering away from economy crises.

> Reduction of Fraud: with regulation, comes higher levels of order and control

> Better tracking of the derivatives market: “investors be able to see the full array of trading in real time” (Gross, 2010)

> Higher levels of clarity regarding the complexities of the derivatives market

> Breaking the control of Wall Street firms over derivatives: they “want things to work the way they did in the last century, when you had to pick up a phone and call somebody to get a price and execute a trade” (Gross, 2010). Regulations facilities for buyers and sellers of such instruments to trade in more regulated exchanges.

Cons: More Regulations of Derivatives

Likewise, a lot of negative attributes surround more regulations of the derivatives markets. Those include:

> Reduction of Risk: A lot of investors are drawn to derivatives because of their higher levels of risk; to them, this means higher profit potential. More regulations mean striking at the very foundations of the derivatives concept; “disguised bets” (Min and Garofalo, 2010). In such case, what’s the benefit of playing poker, when everyone can see your hand?

> Removal of the element of speculation: more regulation might mean the shrinking of the derivatives market. Robert Pickel, chief executive of the International Swaps and Derivatives Association, welcomes more regulations, yet he urges policymakers to make sure that such “reforms help preserve the widespread availability of swaps and other important risk-management tools” (Cho and Goldfarb, 2009).

> Lower profits: “The more transparent a marketplace, the more liquid it is, the more competitive” (Min and Garofalo, 2010). Though this may be good for the economy, but higher levels of competition, will ultimately result in lower profits to the dealers of derivatives.

Concluding Remarks

In the end, when a crisis does fall upon an economy, the most affected people are the investors; all the other individuals are temporarily inconvenienced [to varying degrees]. Given that fact, higher regulations of the derivatives market do bring with them added benefits to the investors. Interestingly enough, for the past several decades “Wall Street has continually told Washington that if the Street can’t do things the way it always has, and if the government changes the rules to mandate greater transparency and customer protection, [they] won’t be able to make money, and it would stunt the industry. They’ve been wrong every time” (Gross, 2010). So in the spirit of more efficient markets, higher levels of regulations should be introduced; but only in controlled doses, as you never know what’s waiting for you in the unknown.

~ Youssef Aboul-Naja