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Do We Really Need Derivatives?

This is a surprising question coming from a guy who spent most of his career trading in the derivatives markets. Nonetheless, the question deserves an answer.

A typical rational for derivatives goes something like this: Say there is an energy company contemplating an oil field development project. They would feel much better about making the investment if they could lock in the current market prices for oil out ten years into the future. To do this they need an oil futures contract. Notice that the use of this futures contract does not change the expected value of the project; it only removes the downside risk if oil prices decline. The hedge accomplishes this by coming with an opportunity cost if oil prices rise, minus the related costs involved in executing the futures trade. On the other hand, say you are an airline. You could remove some of the downside risk to your income statement by buying the futures contract that the energy company wants to sell. This way, you won’t be adversely affected by high fuel costs if oil prices skyrocket. Like the oil company, you also give up potential benefits plus incur some costs. If these two companies manage to meet in the futures market everyone is better off, right? As University of Chicago economist Merton Miller put it in a 1994 paper: “Derivatives use has grown, I insist, because they have satisfied an important business need; they have allowed firms and banks, at long last, to manage effectively and at low cost business and financial risks that have plagued them for decades, if not for centuries.”

Not so fast. The first objection one could raise is that the risk is not “managed” - it is merely transferred to another party via a leveraged instrument. Since it is unlikely both firms would meet at the exact time each wanted to hedge, a liquid marketplace for derivatives needs to exist, requiring liquidity providers, regulators and infrastructure. It is indeed true that from the perspective of the CFO’s of the participating hedgers the risks have been managed. In this microcosm of the economy, they have managed to smooth their company’s earnings, perhaps with the expectation that the market will reward this accomplishment with a higher PE ratio. However, from the perspective of a potential stock investor, this financial sleight of hand is less than impressive. If an investor was concerned about oil prices, she could buy both the energy company and the airline, thus netting out her exposure to oil prices. This would be accomplished without the costs required to compensate the liquidity providers and pay for the overhead in running and regulating the derivatives marketplace.

Where derivatives do have value is when their insurance (hedging) and risk redistribution properties allow sound investments to proceed when they would otherwise be perceived as too risky. In this context, derivatives offer two benefits to society: they allow an attractive investment to move forward (thereby increasing our standard of living) and they insure against business failure (a good company is worth more than the sum of its parts). In the case of business failure there is an additional net loss to society as our legal system consumes some of the remains of the deceased. At a certain sweet spot, these benefits exceed the economic rents required to sustain the derivatives market by a maximum amount. Finding this sweet spot should be a focus of our regulators, politicians and captains of industry.

As is typical in free market economies, we may have overshot the target. It may (or may not) surprise you to know that the notional value of all derivatives contracts adds up to a value many times greater than our collective wealth. According to the Bank of International Settlements (NASDAQ:BIS), the total amount of outstanding derivatives has surpassed one quadrillion dollars. Yes, over 1,000 trillion dollars worth. Advocates of derivatives, those who profit from their creation, marketing and trading, will reply that while this is true, many of these exposures net out, suggesting that there is nothing to worry about. The basic idea here can be summarized as follows: Joe is worried that Jim will default on a loan, so Joe buys a credit derivative (swap) from John. John worries about Jim's industry so he buys a swap on a basket of stocks from James to protect himself. James lenders hear about the swap he sold and fear developments in the market may put them at risk so they go to Jim and buy credit protection against James defaulting. In this case tell me, what is the net exposure?

I have a hard time believing this is what the founders of derivatives had in mind. We should not encourage the concentration of derivatives exposures (as in the financial sector) in highly leveraged vehicles (such as financial companies). For derivatives to create the most value they need to be widely distributed in a relatively unlevered way in order to promote the sharing of risk among investors without creating systematic vulnerability. Let’s hope our regulators keep this in mind. If not, we will be facing a new kind of plague that will dwarf the one Merton Miller thought derivatives would cure.

Disclosure: "No Positions"