James Rickards is a hedge fund manager in New York City and the author of Currency Wars: The Making of the Next Global Crisis from Portfolio/Penguin. Follow him on Twitter at @JamesGRickards.
The idea that the financial products known as derivatives pose a danger to the financial system is nothing new. Commentators have been pointing this out for years. Most famously, Warren Buffett referred to derivatives as "time bombs" and financial "weapons of mass destruction." Recently a complex derivatives trade caused over $5 billion in losses at J.P. Morgan.
Derivatives are bets between two parties that are made today with a payoff in the future based on the value of some stock, bond, or index. One party will profit if the reference security or index goes up in value and the other party will profit if it goes down. These bets usually settle up every three months based on value at that time, and then a new calculation period begins. There are many variations on this basic pattern, but almost all derivatives involve some form of a bet in which gains and losses are calculated and settled-up periodically.
If derivatives are as dangerous as the commentators suggest, why are they permitted? If they are such a threat to the financial system, why does the size of derivatives bets continue to grow? The answers have to do with several myths the big bank derivatives players have created. These myths are false and distract interested parties from doing what needs to be done to ban derivatives. It's time to demolish these myths once and for all.
Myth No. 1: Derivatives break up risk into parts and allow the pieces to be put into strong hands best able to absorb losses. Financial transactions do involve multiple risks. Even a simple loan can have interest rate risk, credit risk, and foreign exchange risk. The original idea behind derivatives was that these risks could be repackaged into separate financial instruments. In the simple loan example, one party could absorb the interest rate risk, another could absorb the credit risk, and still another could absorb the foreign exchange risk. Since each party specialized in a certain type of risk, it could offer the best prices so that the entire package would be cheaper to the customer than having a single bank absorb all of the risk on its books.
The problem with this simple view is that most derivatives do not derive from an original loan or investment, but are created exclusively to make new bets. Instead of moving risk into strong hands, derivatives actually create risk out of thin air. Risk is not being reduced by derivatives, it is growing exponentially.
Myth No. 2: Derivatives allow markets to get valuable price information about the underlying security or index on which the derivative is based. This process of getting market information from actual trading is called "price discovery." This rationale is heard frequently in the credit default swap market—basically bets on whether a company or country will go bankrupt. Supporters say that prices in the credit default swap market provide good information about the financial health of countries in distress such as Greece or Spain.
This explanation ignores that fact that such price information has always been available from the underlying bonds themselves. The market doesn't need credit default swaps to tell it Greece is in trouble. The market in Greek bonds shows directly that prices are falling and borrowing costs are going up and that Greece is in financial distress.
In fact, the actual bond market is a much better indicator of financial health than the swap market because bonds are widely held by a large number of investors, while the credit default swap market is tightly controlled by a small number of major bank dealers who set prices in a nontransparent way. The credit default swap market is much easier to manipulate than the underlying bond market and therefore it's easier to create a sense of panic which often benefits the dealers in this kind of credit insurance. Derivatives to not improve price discovery, they make it easier to manipulate markets.
Myth No. 3: Bank management has derivatives risks under control using mathematical models that capture the complex interaction of factors embedded in derivatives trades. This view is laughable on its face given the continual series of notorious derivatives fiascoes from Long-Term Capital Management to AIG to J.P. Morgan and many others.
Yet, this myth is pernicious at a deeper level because many bank managers actually believe it. They have constructed elaborate management tools based on empirically false assumptions about the frequency and severity of bad events and the correlations among them. Risk managers sometimes acknowledge these limitations but then say their tools are "better than nothing." This is false too. Bad tools are not better than nothing. They lead to bad investments with the taxpayers picking up the losses every time things go wrong. It would be more honest to admit what we don't know and limit derivatives until the state of the art improves.
The next time some derivatives proponent says that derivatives reduce risk, increase transparency, and are well hedged, stop them in their tracks and ask if they believe in tooth fairies, Easter bunnies and leprechauns. Actually, it's safer betting on the leprechauns than in the soundness of modern derivatives finance. Since markets seem not to have learned from past disasters, one should expect worse to come.