Derivatives are the weapon of choice…

Washington is starting to get serious about the regulation of Credit Default Swaps.  Via the internet, I caught some of the testimony before the Senate Agriculture Committee.  I particularly enjoyed Rick Bookstaber’s assessment, “Derivatives are the weapon of choice for gaming the system.”   After acknowledging the original economic purpose of derivatives, i.e. risk managment, he continued:

As time progressed, however, derivatives found use for less lofty purposes. Derivatives have been used to solve various non-economic problems, basically helping institutions game the system in order to:

  • Avoid taxes. For example, investors use total return swaps to take positions in UK stocks in order to avoid transactions taxes.
  • Take exposures that are not permitted in a particular investment charter. For example, index amortizing swaps were used by insurance companies to take mortgage risk.
  • Speculate. For example, the main use of credit default swaps is to allow traders to take short positions on corporate bonds and place bets on the failure of a company.
  • Hide risk-taking activity. For example, derivatives provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored. Derivatives also can be used to structure complex risk-return tradeoffs that are difficult to dissect.

These non-economic objectives are best accomplished by designing derivatives that are complex and opaque, so that the gaming of the system is not readily apparent.

For a balanced and thoughtful view of the regulation of derivatives, you might want to read his entire written testimony here (pdf file).  His piece offers an excellent summary of the uses and misuses of derivatives and how that can spill over into market and economic consequences.

Another witness before the committee, Professor Lynn Stout of the UCLA Law School, pointed out how Credit Default Swaps have become overwhelmingly used as speculative tools, not risk management tools:

[I]t is clear that by 2008, the market for CDS, for example, was primarily a speculative market….  We know this with mathematical certainty because by 2008, the notional value of the CDS market (that is, the dollar value of the bonds on which CDS bets had been written) had reached $67 trillion.  At the same time, the total market value of the underlying bonds issued by U.S. companies outstanding was only $15 trillion.  When the notional value of a derivatives market is more than four times larger than the size of the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging. And both economic theory and business history associate speculative markets with serious negative economic consequences.

The overwhelming speculative volume in the Credit Default Swap marketplace is a good example of “overspeculation,” an excessive diversion of investment capital away from traditional vehicles and into pathways that ultimately distort and undermine the markets.

The hearings were quite interesting in tone as well.  As opposed to many of the hearings last year (like the one I participated in with the House Agriculture Committee), the financial services industry seemed very much on the defensive yesterday.  Hopefully, this will allow some of the much-needed reform of the derivatives market to proceed.

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