Financial Derivatives Must Be Banned

 |  Includes: KBE, KRE, XLF
by: Josh Dowlut

There is a huge difference between agricultural derivatives or commodities derivatives, which serve a legitimate purpose, and financial derivatives, which should be outright banned as they were from 1907-1999.

Almost every argument I've read in favor of derivatives mentions the benefits of the agricultural/commodities/currency type. A farmer bringing grain to market who wants to guarantee a delivery price. A manufacturer buying components across multiple currencies who wants to lock in an exchange rate. Airlines that want to be able to sell tickets in advance based on a specific price of jet fuel. All these serve legitimate purposes. They also all have one thing in common: one party to the "bet" has a bona fide vested interest in the asset being bet on.

A financial derivative, on the other hand, is a financial instrument whose value is determined by the value of another financial instrument, often times with neither party having any actual ownership in the underlying, determining financial instrument. The natural question that comes to mind is "why not just buy ownership in the underlying/determining instrument directly?" The purported reason is they increase price discovery and allow investors to fine tune their risk exposure thereby improving the efficiency of capital markets thus improving how capital is allocated throughout the real economy.

The truth is financial derivatives were a primary, proximate cause of the meltdown we just witnessed. Financial derivatives as we know them are an invention of the last 10 years having been effectively banned from 1907-1999. Is anything being done to undo the recent laws that created this? No, and we are kidding ourselves to think that they can be regulated.

Two guys bet against each other over the outcome of football game: illegal.

Two investment bankers bet against each other over the outcome of a pool of loans: perfectly legal.

We built the transcontinental railroad, the interstate highway system, the national telecom network, the electrical grid, cured multiple diseases, and sent a man to the moon without the widespread use of financial derivatives. Within less than 10 years of their widespread use, the entire system nearly imploded and all we got to show for it were some new homes we'll be disputing the ownership of for some time.

Disclosure: No positions