Smith Faculty Opinion Article
April 21, 2010
Derivatives are as ancient as civilization.
Greek famers insured crops with investors prepared to speculate on the
weather, just as life insurers hedge mortgage-backed securities by purchasing
credit default swaps.
When written against real assets-farmers' crops or homes--derivatives spread
risk, lower capital costs and foster growth.
Like any other financial contract, derivatives can be abused, and the big
bonus culture on Wall Street has given us some high profile shenanigans.
How derivatives are regulated or overregulated is central not just to curbing
excess, but to ensuring that farmers can plant, home buyers can borrow, and
businesses can invest.
Controversy about reform centers around three issues. Creating a platform
similar to commodities future exchanges to push some 95 percent of trading from
the over-the-counter market into those exchanges; banning banks-institutions
taking government guaranteed deposits-from running trading desks and holding
positions; and limiting synthetic securities.
Derivatives often have specialized purposes. For example, chemical
manufacturers and life insurers have exposures to energy prices and interest
rate movements that vary a lot, and these companies need specialized hedges.
Pushing virtually all transactions through standardized contracts on public
platforms will work poorly, concentrate risks and lower economic growth.
Virtually all of the 200 banks that failed over the last two years had no
trading desk. Most failed making lousy loans and investing in poor commercial
mortgage backed securities. Now, investment banking activities-yes trading-is
helping to redeem Citigroup.
Banning banks from derivatives makes little sense, unless we bring back Glass
Steagall by restricting banks to taking deposits, making loans and holding
government debt. Congress has no stomach for that.
Banks provide trust services and make markets in municipal and state
bonds-both vital services. Banks need to hedge positions, and the recent
financial crisis would not have been averted had J.P. Morgan, Citigroup and
other big banks been banned from derivatives trading.
Estimates of the SWAPs market range from $450 to $600 trillion in a global
economy less than one-fifth that size. The market is so large, because
speculators are writing synthetic securities- positions on securities that
neither party owns. It's like buying insurance on a North Carolina beach house
you don't own.
The scale of those markets can instigate financial calamity when underlying
asset prices abruptly move-for example, housing prices after 2006-and synthetic
securities do little to mitigate risk and aid investment and growth in the real
Arbitrary limits won't work. Derivatives are simple contracts among
consenting adults, and we know how laws to enforce private morality work-they
We can require banks, licensed securities dealers and the like to only sell
contracts when the originating party posts adequate resources to pay if prices
drop abruptly on underlying assets. That was missing at AIG when its house of
cards collapsed and would limit the scale of the market.
The rest that is being proposed is Washington excess. Fixing what is not
broke and breaking what is running better than we now recognize.
Peter Morici is a professor at the University
of Maryland School of Business and former Chief Economist at the U.S. International