In a paper published in 1999, Martin Mayer of the Brookings Institute wrote, “The system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries — their knowledge of their borrowers, and their incentive to police the status of the loan.”
In the 15 years that have passed since “The Danger of Derivatives” was published, the most important change has been the size of that danger and a deeper understanding of how difficult it is to regulate our way past it.
Put simply, a “derivative” is an investment that derives its value from something else. When you buy a derivative, you are not buying any physical thing, such as a share of a company or a debt with regular payments, but either the right or an obligation to assume something more tangible later.
When used properly, derivatives are not as complicated or as sinister as they sound.
In 1730, the Dojima Rice market began trading futures in order to help stabilize prices. A “future” is the most classic type of derivative, and it is only the right to buy something at a future date. Say you depend on rice to keep your factory open or to feed your family, a future contract to purchase a sack of it next year for $25 at the price of $5 today is useful insurance. You’ve spent no more than $30 to assure that you have enough rice next year, no matter what happens in the way of bad weather or other problems, and the farmer has $5 to help plant the crop.
From these early beginnings as insurance that benefited consumer and farmer alike, derivatives have grown considerably. They represent many kinds of insurance against losses of all kinds, including financial default.
Regulating “a very high-stakes casino”
«The derivatives market has done so much damage to our economy and is nothing more than a very high-stakes casino – except that casinos have to abide by regulations,» wrote Sen. Maria Cantwell (D-WA) in support of her bill, co-authored by Senators Ron Wyden (D-Ore.) and Bernie Sanders (I-VT), to regulate the industry as if it were, indeed, nothing more than gambling.
It reached that point through a complete lack of regulation or even understanding of how big the industry became. Paul Wilmott, a leading expert on derivatives estimates, “The total world market for derivatives may be as high as $1.2 quadrillion,” or about 20 years of the total product of the entire planet. No one is exactly sure, though, because most derivative trades are unrecorded and off the balance sheets.
A quadrillion is a thousand trillion, or a million billion. It’s a very big number.
The “notional value,” or value of the total assets which derivatives are sold against, reached $26 trillion for just those that are traded on exchanges in 2013, according to the Bank for International Settlements. But they also know of $692 trillion in derivatives registered and appearing on balance sheets somewhere.
There is a move to regulate these trades, or at least record them.
“Once you start looking into what’s off-balance sheet and how to deal with off-balance sheet activities gross or net, that’s when it gets more technical and more complicated, that’s where also the devil is in some of the details,” said Stefan Ingves, head of Sweden’s central bank.
“A zero-sum game”
The explosion in derivatives came with the acceptance of the credit default swap (CDS), or insurance against the default of a line of credit or bond. That may sound reasonable enough, but it is perfectly legal to take out that insurance without holding the underlying debt. You can take out a bet that a particular loan will or will not fail, even if you have no interest in the debt other than speculation.
“Derivatives are gambling,” according to Lynn Stout, a corporate law professor at University of California, Los Angeles. “They are a zero-sum game in which one side loses the bet and one side wins.”
The size of the gamble became so large in part because of leveraging, or borrowing against the position in derivatives to obtain more money to buy more derivatives. The underlying asset borrowed against is a gamble, but it is used as 5 percent down or less to borrow money to do more gambling.
That was how investment bank JP Morgan Chase was able to lose $6.3 billion so quickly in the famous “London Whale” incident of 2012. One bet went bad and the whole structure that was based on it failed. But the real problem was that the bank itself didn’t understand the amount of risk it took on. CEO Jamie Dimon admitted, “The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.”
“We want to catch leverage in a reasonable way, because one of the things that history has taught us is that when you look at episodes ex-post, when things fall apart, the conclusion is almost always that there was somehow too much leverage in the system and it was found out way too late,” Ingves said.
Ingves’ statement aligns with the focus of most of the regulation that has been proposed so far.
The Dodd-Frank Financial Reform Bill was due to take effect in 2013. It requires that standardized CDSs be traded on exchanges, be cleared through clearing houses, and be subject to regulatory supervision. In other words, standardized swaps wind up being a lot like futures. «Once these 3 things are done, standardized and standardizable swaps become virtually indistinguishable from futures type contracts,» according to MIT economist John Parsons, an economist at Massachusetts Institute of Technology.
While they may be “virtually indistinguishable from futures type contracts,” at least they would be transparent and measured.
No international agreement
It hasn’t been working, though, largely because the international banking system has outgrown the boundaries of nations that write laws and regulations. The European Union can’t even agree on a standard definition of a derivative because there are 28 nations with 28 different histories in financial markets.
International cooperation has been delayed by the Commodities Futures Trading Commission until the mess can be sorted out. «If you insist on these hard deadlines, and if they’re too aggressive, it stands to reason that it will throw firms out of compliance,» said CFTC Chair Mark Wetjen.
So it stands today where most observers of the financial markets are unsure exactly how much is outstanding in derivatives, but they are willing to call them nothing more than a gamble. That gamble is highly leveraged and vulnerable to small changes that could cause big problems throughout the system.
Yet, it is still largely unregulated or even properly recorded because there is no international agreement — all despite the fact that the problem has been understood for a very long time.