Almost all financial derivatives trading adds nothing but risk to the world and should be banned. It won't be, but that doesn't mean the debate is academic.
Regulators are attempting to bring derivatives into the light through mandatory exchange execution and clearing and "Legal Entity Identification" rules, but progress is slow and fragile. It can be filed under "B" for believe it when we see it.Please note that derivatives could easily be brought into the light if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
Disclosing their exposure details would disclose their derivative positions.
But is there any reason to allow financial derivatives at all?
New York hedge fund manager James Rickards says they should simply be banned because the benefits are illusory and the effect is that risk is created out of thin air and then multiplied....
Most derivatives trading involves swaps or contracts for difference, where two people bet on movements in an underlying asset or income flow without actually trading in it. It's a bit like betting on flies crawling up a wall, without having to buy the flies....
Credit default swaps are bets on whether a country or company will go broke; interest rates swaps are bets on movements in interest rates; contracts for difference are bets on movements in a share price or other asset; and so on....I wouldn't say that derivatives caused the 2008 global financial crisis. Derivatives clearly contributed to the magnitude of the crisis.
In fact, derivatives caused the 2008 global financial crisis because banks and investment banks vastly multiplied the leverage on their balance sheets by betting through derivatives and then losing control.
Since then, the amount of derivatives outstanding has actually grown, and now stands at more than $700 trillion....Requiring the banks to disclose their derivative positions would have an immediate impact on restraining growth in the amount of derivatives outstanding and would give banks an incentive to shrink their derivative exposures.
Disclosure of their derivative books means that banks are subject to having their cost of funds linked to the risk they are taking. The more risk in their derivative book, the higher their cost of funds.
This form of market discipline restrains growth in derivative exposures and provides an incentive to reduce the risk of the derivative exposures.
Nevertheless, regulators are grinding their way through consultation and report production with a view to eventually dragging OTC derivatives trading into the open, where the players at least have to say who they are.
The US Dodd-Frank legislation, passed in 2010, requires non-US banks to register as swap dealers with US regulators from next year if they want to trade derivatives there.
Guess what? Reuters reported last week that Asian banks are cutting their relationships with US banks so they don't have to register, and US banks themselves are restructuring so they can keep going.Proving that complex rules and regulatory oversight are not a substitute for transparency and market discipline.
Let's be clear: basically, we're talking about a casino where the gamblers are banks. And banks aren't just any old punters: they also take deposits and lend money, underpinning the financial system on which society rests.
As with all casinos, someone always loses their shirt occasionally - LTCM in 1998 (US$4.6 billion), UBS in 2011 ($2 billion), AIG 2008 ($18 billion), Barings in 1995 ($1.2 billion), Societe Generale in 2008 ($7.2 billion), and so on.
The losses of shirts don't always cause a general financial crisis, but there's always a wobble, and in 2008, the combination of AIG, Merrill Lynch and Lehman Brothers and a few others did cause a global recession and is still causing widespread misery....The only way to restrain bankers' desire to gamble is by requiring they disclose their exposure details.
As Jamie Dimon and JP Morgan showed with the London Whale trade, if banks are forced to disclose their positions, fear of the market trading against them will cause them to exit the position as soon as possible.